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Introduction to Build-to-Suit Exchanges
By Gregory J. Rocca and Michael K. Phillips
Copyright 2005 Pacific Realty Exchange, Inc. All rights reserved.

For various reasons, taxpayers may want to exchange for newly constructed property. The fact patterns range from a build-to-suit factory for the taxpayer’s business to improvements for a “fixer-upper” rental house. Sometimes the build-to-suit property is the raison d’etre for the exchange. Sometimes the improvements are an afterthought to avoid boot because the taxpayer is short on value or long on exchange funds. Irrespective of the fact pattern, build-to-suit exchanges often present difficult issues.

There is a long line of cases and rulings that have allowed built-to-suit exchanges. A taxpayer may locate suitable property to be received in an exchange and enter into negotiations for the acquisition of such property. Coastal Terminals, Inc v. United States, 320 F.2d 333, 338 (4th Cir. 1963); Alderson v. Commissioner, 317 F.2d at 790 (9th Cir. 1963); Coupe v. Commissioner, 52 T.C. 394 (1969). A party can hold transitory ownership of exchange property solely for the purposes of effecting the exchange. Barker v. Commissioner, 74 T.C. 555 (1980). Moreover, the taxpayer can oversee improvements on the land to be acquired, J.H. Baird Publishing Co. v. Commissioner, 39 T.C. 608 (1962), and can even advance money toward the purchase of the property to be acquired by exchange. 124 Front Street Inc. v. Commissioner, 65 T.C. 6 (1975); Biggs v. Commissioner, 632 F.2d 1171 (5th Cir. 1980), aff’g 69 T.C. 905 (1978).

The IRS has also approved exchange transactions in which the replacement property was built to suit the requirements of the exchanging taxpayer. For example, in Rev. Rul. 75-291, 1975-2 C.B. 332, a corporation (X) agreed to exchange its land and factory for land to be purchased by another (Y) and improvements to be constructed thereon. The ruling stated that Y ‘built the factory solely on its own behalf’ and ‘not as an agent of the taxpayer,’ and X was allowed nonrecognition treatment. The key to Rev. Rul. 75-291 is that the unrelated buyer purchased the land and constructed the building for its own account and did not act as the taxpayer’s agent. The taxpayer exchanged for improved property, not for land and construction services. The construction was done and the value was added while an independent party owned the land. These are the essential requirements for any build-to-suit exchange.

It is equally clear that the taxpayer cannot “exchange” his old property for a building constructed on land that the taxpayer already owns. In such a case, the taxpayer is not exchanging “property”, but is merely paying for construction services. Further, if the contractor constructs the building as the taxpayer’s agent or never owns the land or new building, the transaction will not qualify for exchange treatment. See Bloomington Coca-Cola Bottling Company v. Commissioner, 9 T.C.M. 666, aff’d 189 F.2d 14 (7th Cir. 1951); DeCleene v. Commissioner, 115 T.C. 457 (2000). Further, the taxpayer cannot use exchange funds to pay for construction services performed after the receipt of the replacement property. Any exchange funds spent on post-acquisition improvements will be taxable boot to the taxpayer. See Reg. Section 1.1031(k)-1(e). Between the clear results of Rev. Rul. 75-291, on the one hand, and Bloomington Coca-Cola, on the other hand, there are numerous unresolved issues if the replacement property will be newly constructed property.

The IRS recently issued Rev. Proc. 2004-51 to address certain build-to-suit exchanges involving land originally owned by the taxpayer. The IRS became aware that some taxpayers interpreted language in Rev. Proc. 2000-37 (which provides a safe harbor for certain parking transactions in reverse exchanges) as permitting transactions in which the taxpayer transfers property to an exchange accommodation titleholder (EAT) and later receives that same property as replacement property in a purported exchange for other property of the taxpayer. The IRS noted that an exchange of property for improvements on land owned by the same taxpayer does not meet the requirements of Section 1031 (citing DeCleene and Bloomington Coca-Cola Bottling Co., supra). The IRS also cited Rev. Rul. 67-255, 1967-2 C.B. 270 which holds that a building constructed on land owned by a taxpayer is not of a like kind to involuntarily converted land of the same taxpayer. The IRS concluded that Rev. Proc. 2000-37 does not abrogate the statutory requirement that the transaction be an exchange of like-kind properties. Accordingly, Rev. Proc. 2004-51 modified Rev. Proc. 2000-37 so that Rev. Proc. 2000-37 does not apply if the property is owned by the taxpayer within 180 days before the transfer to an EAT. The IRS also stated that it was “continuing to study parking transactions,” including transactions in which a related party transfers a leasehold in land to an accommodation party and the accommodation party makes improvements to the land and transfers the leasehold with the improvements to the taxpayer in exchange for other real estate. See PLRs 200251008 and 200329021 discussed below.

Construction Exchanges in Reverse of “Semi-Reverse” Exchanges
By Gregory J. Rocca and Michael K. Phillips
Copyright 2005 Pacific Realty Exchange, Inc. All rights reserved.

In PLR 200251008, the IRS addressed the qualification of a build-to-suit exchange under the administrative safe harbor for reverse exchanges under Rev. Proc. 2000-37. The replacement property consisted of a new 32-year sublease from a related party and improvements made by the EAT. The IRS also addressed the safe harbor for a QI which was applicable to the reverse exchange using the “exchange last” method. A reverse exchange where the replacement property is parked with an EAT may actually be a simultaneous exchange with a QI which closes when the relinquished property is sold by the QI. The EAT simply sells the improved replacement property to the QI and the property is transferred to the taxpayer to complete the exchange. This was the form of the transaction in the ruling. Finally, the IRS examined the issues presented by construction of the improvements within the 180-day period of Rev. Proc. 2000-37, including any failure to complete improvements before the EAT’s transfer of the replacement property and potential boot to the taxpayer. These holdings, in and of themselves, were straightforward. What is most interesting about PLR 200251008, however, is the newly-created 32-year sublease from a related party to the EAT. Without that lease, the taxpayer’s exchange would not have qualified under Section 1031 since only leases with a term of 30 years or more to run are treated as of like kind to a fee interest. Further, a taxpayer cannot exchange property for construction services on land that it already owns but in this case the land was controlled by a related party, not the taxpayer itself.

Facts of PLR 200251008. An S corporation (“Taxpayer”) operated a business on the relinquished property (RQ). Taxpayer owned a fee interest in RQ and all improvements thereon. CorpW was an S corporation that was related to Taxpayer. CorpW leased land as lessee land under a lease (“Lease”) with a city as lessor. The Lease’s term was 45 years and had one 15-year renewal option. LLC-W, a limited liability company, was related to CorpW and Taxpayer. LLC-W subleased the land from CorpW and all rights, title, interest and obligations under the Lease for the entire term of the Lease. LLC-W planned to utilize the land, in part, as the new location for Taxpayer’s business that was currently operated on RQ. LLC-W was developing and constructing the infrastructure required so that the business could be moved to the land. Taxpayer and CorpW were each owned half and half by Husband’s Trust and Wife’s Trust, respectively. LLC-W was owned 45%, 45% and 10%, respectively, by Husband’s Trust, Wife’s Trust and a minority member.

Buyer and Taxpayer entered into an Option Agreement for Sale and Purchase of RQ (Sale Agreement). Under the Sale Agreement, the Taxpayer agreed to sell RQ to the Buyer. However, Taxpayer arranged to have the transfer of RQ to Buyer structured as a like-kind exchange under Section 1031. To facilitate a future exchange, Taxpayer used the qualified exchange accommodation arrangement (QEAA) safe harbor provided in Rev. Proc. 2000-37, with an exchange accommodation titleholder (EAT). The EAT acted through a single-member LLC, Titleholder. Taxpayer also used the qualified intermediary safe harbor rules by entering into an exchange agreement with a qualified intermediary (QI). Initially, the QEAA was between Taxpayer and EAT. Later, Taxpayer’s rights under the QEAA were assigned to QI to facilitate transfer of the replacement property (RP) from EAT to Taxpayer. Titleholder was created to enter into the sublease and take title to RP. Titleholder was a limited liability company, with EAT as its sole member, and disregarded for federal income tax purposes.

The entire transaction can be summarized in the following steps: (1) Taxpayer enters into the QEAA with EAT, and enters into an exchange agreement with QI as described. (2) LLC-W subleases RP at a fair market rental for 32 years, to Titleholder, a disregarded entity wholly owned by EAT, as part of a QEAA. (3) Taxpayer lends to Titleholder the funds which Taxpayer borrows from Husband’s Trust, Wife’s Trust and Bank to construct improvements on leased property for the relocation of Taxpayer’s business. (4) Taxpayer assigns its rights under the Sale Agreement to QI and gives required notices of such assignment to all interested parties. (5) Taxpayer transfers RQ free and clear through QI to Buyer and QI receives the sales proceeds. (6) Taxpayer assigns its position in the QEAA to QI and gives required notices of such assignment to all interested parties. (7) QI uses the sales proceeds from RQ to pay EAT for all of its ownership interest in Titleholder (which holds all of RP, consisting of the 32-year sublease and newly constructed improvements to suit Taxpayer’s business requirements). (8) EAT uses the proceeds received from QI to pay Construction Manager and to pay the loan from Taxpayer in full (which Taxpayer, in turn, uses to pay the Bank Construction Loan in full). (9) QI directs EAT to transfer its membership interest in Titleholder (which holds RP) directly to Taxpayer.

IRS’s Holding. The IRS ruled that (1) Taxpayer’s exchange will conform with the requirements of the QI and the QEAA safe harbor rules, so that QI and EAT will not be agents of Taxpayer and Taxpayer will not be in actual or constructive receipt of money or other property before receiving RP; and (2) Taxpayer will not recognize any gain upon the transfer of RQ to Buyer and the receipt of RP, except that if planned improvements are not completed within the exchange period, gain will be recognized to the extent of any boot received in the exchange. Implicit in the IRS’s holding is recognition of and respect for the newly-created 32-year sublease from the related party. The IRS assumed that this sublease was bona fide since it provided for market rent. The IRS did not raise any issues other than the Section 1031(f)(1) issue (and that was a concern for the IRS only if there was a subsequent disposition by the taxpayer or related parties of their respective leasehold interests in the two-year period). The IRS simply concluded that since the sublease had a remaining term of 30 or more years, the sublease and improvements were of like kind to the fee interest in the relinquished property. The IRS also did not express any concern that the transaction was, in essence, a non-like-kind exchange of land for construction services.

In PLR 200329021, the IRS approved a leasing structure similar to the structure used in PLR 200251008 to build improvements on land leased to and controlled by a related party. In PLR 2003290021, a parent corporation (Parent) held a leasehold interest as lessee in land owned by an unrelated party. Parent is the sole shareholder of several subsidiaries, including the exchanging taxpayer (“Taxpayer”). The Taxpayer holds title to fee-owned properties with certain business facilities. The facilities are operated by Parent, and Parent provides compensation to the Taxpayer for use of the facilities. The lease to the Parent was a ground lease which entitled the Parent as lessee to construct certain types of real property improvements. The lease was for a period of twenty years with four 5-year renewal options held by the lessee. Thus, the lease had a potential term of 40 years. The lease was on arm’s-length commercial terms with the unrelated owner of the land. The leasehold interest was never the property of the Taxpayer.

Facts of PLR 200329021. The Taxpayer, a wholly-owned subsidiary of Parent, was disposing of fee interests in its business sites (relinquished property) and wanted to receive the lease with newly constructed improvements (replacement property). The Parent assigned its leasehold interest to a single-member limited liability company (LLC) whose sole member was an exchange accommodation titleholder (EAT). The EAT was represented not to be a “disqualified person” and also served as the qualified intermediary (QI) in the Taxpayer’s deferred exchange. Within five days, the Taxpayer, EAT, and LLC entered into a qualified exchange accommodation arrangement (QEAA) under Rev. Proc. 2000-37. Fee interests in relinquished property were sold in a deferred exchange with the QI, and the QI received the sales proceeds.

The Taxpayer represented that the exchange would be completed within 180 days after the earlier of (i) the Taxpayer’s transfer of the relinquished property in the deferred exchange or (ii) the LLC’s acquisition of the leasehold interest. Under Parent’s supervision, the LLC constructed improvements on the leased property according to plans and designs provided by Parent. The QI made monthly disbursements to the LLC from the net exchange proceeds (which the QI received on the sale of the relinquished property). The monthly disbursements allowed the LLC to make payments to the general contractor constructing the improvements. The LLC also reimbursed Parent for the third-party planning costs incurred in planning the construction of the improvements.

Before the end of the 180-day period, the Taxpayer assigned its rights under the QEAA to the QI. The QI then transferred the balance of the Taxpayer’s exchange proceeds to the LLC, and the LLC transferred the leasehold interest and improvements to the Taxpayer to complete its exchange. The IRS implicitly held that this structure avoided the problems created by Bloomington Coca-Cola Bottling Co. v. Commissioner, 189 F2d 14 (7th Cir 1951). Further, the Taxpayer represented that neither the Taxpayer nor Parent had any current intention to sell or otherwise dispose of the replacement property after it is acquired. Based on this representation, the IRS specifically held that the structure avoided the problems created by Section 1031(f) in general and Section 1031(f)(4) in particular. Under the QEAA Agreement, the purchase price to be paid for the acquisition of RP will be equal to the costs incurred by LLC in constructing the Improvements and acquiring the Leasehold Interest, including capitalized costs such as accrued rent, real estate taxes, and planning costs. The final purchase price will be determined immediately before the end of the 180-day period. If the actual purchase price exceeds the qualified funds held by QI, the excess purchase price will be paid in cash by the Taxpayer or will be paid by the Taxpayer by assuming the outstanding indebtedness of LLC for the construction period expenses. If the actual purchase price is less than the qualified funds held by QI, and if the Taxpayer does not timely identify and acquire additional like-kind replacement property in the deferred exchange, the Taxpayer will receive the remaining qualified funds as boot.

Analysis of PLR 200329021. These facts stretch the envelope of “form over substance” further for build-to-suit exchanges involving land controlled by a related party. PLR 200329021 had even more “aggressive facts” than PLR 200251008 in that (1) the related party was the parent corporation of a consolidated group of corporations and the taxpayer was a wholly-owned subsidiary; (2) the parent corporation itself operates and uses the facilities (although it compensates the wholly-owned subsidiary for such use); (3) the lease was assigned rather than subleased; (4) there was no ownership by any “minority member” of any interest in the entity owning the original leasehold (in PLR 200251008 there was a 10% ownership by a “minority member”); (5) prior to the taxpayer’s receipt of the replacement property, the QI made monthly disbursements of deferred exchange funds to the EAT to pay the general contractor and to reimburse the parent corporation for third-party planning costs; and (6) these disbursements were held not to have violated the “(g)(6) limitations” (in PLR 200251008 the exchange appeared to be simultaneous under the “exchange last” method).

It remains doubtful, however, that the IRS would approve of a similar transaction if the EAT had acquired a leasehold interest in land owned by the taxpayer and then constructed improvements. See Rev. Proc. 2004-51 discussed above. In PLR 200329021, the Taxpayer expressly represented that the leasehold interest was never the property of the Taxpayer. Rather, the assigned leasehold interest was previously acquired by Parent under a ground lease with an unrelated landlord. If the EAT acquires a leasehold in land owned by the taxpayer itself, the IRS may assert: (1) in substance, the transaction is a prohibited exchange of property for construction services; (2) in form, the transaction violates Bloomington Coca-Cola Bottling Co., supra upon the merger of the acquired leasehold and the previously owned fee; and (3) the lease should be disregarded under the “step transaction” doctrine. See DeCleene v. Commissioner, supra.

A key fact in both PLRs was that the leasehold interest had 30 or more years to run at the time it was acquired by the taxpayer. Thus, the taxpayer is exchanging a fee interest in improved real estate for a long-term lease of land for a period of 30 or more years and improvements. Such properties are of “like kind” under the example in Treas. Reg. Section 1.1031(a)-1(c)(2). The rulings also noted that the courts have permitted taxpayers “great latitude” in structuring build-to-suit exchanges and cited many of the key cases. But the IRS did not specifically mention Boise Cascade Corp. v. Commissioner, 33 T.C.M. 1443 (1974). The facts in Boise Cascade Corp. are remarkably similar to the facts of PLR 200329021, except that the parent corporation in the ruling assigned its leasehold interest rather than sold the land upon which the improvements were made.

The taxpayer in PLR 200329001 could point to Boise Cascade Corp. v. Commissioner, as comparable authority to support its tax treatment of the transaction. In that case the court held that land and improvements qualified as like-kind property under Section 1031, even though the parent corporation sold the replacement property land to an unrelated buyer, leased back the land for 15 years with an option to repurchase it at the same price, supervised construction and was responsible for cost overruns, and arranged for the improvements to the land while title was held by the unrelated buyer. The court found that title to the land did in fact vest in the unrelated buyer while the improvements were constructed (similar to the qualified indicia of ownership in the lease acquired by the EAT through the LLC in PLR 200329001). According to the court, the fact that the unrelated buyer granted a lease and an option to repurchase back to the parent corporation affected only the “grade or quality” of the property and did not make it different in kind or class. The court also held that the substance of the transaction was consistent with the form, and that planning and arranging for such an exchange is permissible under Section 1031 even if it is done for tax purposes.

Both the IRS and the court in Boise Cascade Corp. recognized that separate taxable entities were involved, even though they were a parent and subsidiary corporation. The court rejected any theory based on “one economic family” in analyzing the substance of the transaction. Rather, the court found that the substance of the transaction was an exchange of like-kind property since the unrelated buyer acquired and held fee title to the replacement property and thus had like-kind property to exchange with the taxpayer. This fundamentally distinguished the case from the Seventh Circuit’s core holding in Bloomington Coca-Cola Bottling Co., v. Commissioner, 189 F.2d 14, 16 (7th Cir. 1951) in which the court stated: “But this is not a case where the contractor exchanged a completed plant owned by the contractor for property and money, hence the contractor at no time had like-kind property . . . . ” [Emphasis added.] In Bloomington Coca-Cola Bottling Co., the form of the transaction was a construction contract and the contractor was engaged to construct a new bottling plant on land owned by the taxpayer. Under the contract, the contractor furnished the necessary material and labor, completed the new building at a price of $72,500, and was paid $64,500 in cash and received the taxpayer’s old plant valued at $8,000. The contractor simply performed construction services and never had like-kind property to exchange with the taxpayer.

PLR 8304022 is the only ruling to address an exchange in which the replacement property is a newly-created leasehold interest together with leasehold improvements constructed on land owned in fee by the taxpayer. This is not only an older private letter ruling but also there is no analysis of the effect, if any, of the taxpayer’s prior and continuing ownership of the fee interest in the replacement property and the applicability of the substance-over-form or step-transaction doctrines to the transaction. For that reason, it is possible that the IRS might reconsider its holding in PLR 8304022 in analyzing a similar transaction today. See Rev. Proc. 2004-51. In PLR 200329021, the IRS specifically noted that the assigned leasehold interest “was never the property of Taxpayer.” In PLR 9243038, the IRS mentioned but did not apply the step-transaction doctrine where there was a seven-year period in between the granting of a 90-year ground lease by the taxpayer and the subsequent exchange for the leasehold interest and improvements on the land owned by the taxpayer. The IRS noted that there was no binding obligation to make the exchange at the time of the lease. But PLRs 200329001 and 200251008 indicate that the IRS may not consider or apply these judicial doctrines at least where (1) there is a business purpose for the transaction (i.e., the taxpayer’s business relocation), (2) the lease is at a market rental rate and is not transitory, and (3) the land is owned by or leased to a related party (not the taxpayer itself).

If the taxpayer sells the land to the accommodator, the transaction may be the most vulnerable to an IRS challenge. See Rev. Proc. 2004-51. An IRS attack most likely would use the same step-transaction approach with which the IRS prevailed in DeCleene v. Commissioner, 115 T.C. 457 (2000). See also Smith v. Commissioner, 537 F.2d 972 (8th Cir. 1976). After their purported exchanges, the taxpayers in DeCleene and Smith ultimately ended up with cash and with property that they previously owned. The application of the step-transaction doctrine to find a taxable sale was not surprising in these cases. If the taxpayer receives a leasehold interest and leasehold improvements as replacement property (and no cash), the transaction may seem less abusive but it is still susceptible to a challenge as an exchange of property for construction services following Bloomington Coca-Cola Bottling Co., supra. See also PLR 8921058 (2/27/89), revoking PLR 8847042 in which the IRS originally approved an exchange of property with a contractor for a townhouse constructed on land previously owned by the taxpayer. PLR 8921058 revoked PLR 8847042 because the IRS was concerned that the transaction was, in substance, an exchange of property for construction services.

In summary, if the replacement property land was previously owned by the taxpayer and improvements are made after either a sale of the property or the granting of a long-term leasehold interest to the accommodator, there is great risk that the IRS or a court will disqualify the exchange as a transfer of property for construction services. If a related party sells the replacement property land for cash within two years of an exchange, Section 1031(f) may disqualify the exchange. See Rev. Rul. 2002-83. However, if a related party (not the taxpayer itself) owns or leases the land, the related party may grant, assign or sublease a leasehold interest to a build-to-suit accommodator. A leasing structure with a related party is certainly the least risky of these alternatives in light of the IRS’s holdings in PLRs 200329021 and 200251008. The IRS has now ruled twice that such a structure avoids the Scylla of Section 1031(f) and the Charybdis of Bloomington Coca-Cola Bottling Co.

Parking Arrangements Involving Build-to-Suit Transactions
By Gregory J. Rocca and Michael K. Phillips
Copyright 2005 Pacific Realty Exchange, Inc. All rights reserved.

Parking arrangements involving new construction may occur in simultaneous, deferred or reverse exchanges. The following considerations are applicable to any parking arrangement involving build-to-suit property. These considerations are especially crucial for build-to-suit transactions that are outside of an applicable safe harbor, such as the safe harbor for certain reverse exchanges under Rev. Proc. 2000-37.

How much control may the taxpayer have over the construction process? It appears that the taxpayer or an affiliate may have a great amount of control over the construction, including the following: (i) undertake preliminary architectural development work, (ii) approve plans and specifications, (iii) approve agreements with the architect and contractors, (iv) have authority over the payments of invoices, and (v) generally supervise the construction. See Boise Cascade Corp. v. Commissioner, 33 T.C.M. 1443 (1974) (taxpayer became “lessee” of new property with title held by the buyer, and as lessee, it could control construction of improvements and disbursement of construction funds); J.H. Baird Publishing Co. v. Commissioner, 39 T.C. 608 (1962), acq. 1963-2 C.B. 4 (taxpayer allowed to oversee improvements and approve payments from the escrow to the construction contractor, in light of buyer’s obligation to deliver a suitable building). In PLR 9149018, the taxpayer incurred costs and did due diligence review of the land, engaged an architect and/or developer to perform design and architectural work, approved plans and specifications, approved construction costs, approved contracts, and paid the architect and developer for work performed prior to the execution of the construction loan and exchange documents. The taxpayer also acted as the construction lender in PLR 9149018.

Can the taxpayer provide funds to finance the acquisition and/or construction? In PLR 9149018, the taxpayer loaned funds to the third party but the third party had to spend an unspecified minimum amount of its own funds prior to any disbursement from the taxpayer’s construction loan. See also Biggs v. Commissioner, 69 T.C. 905, aff’d 632 F.2d 1171 (5th Cir. 1980) (taxpayer advanced entire purchase price to facilitator to acquire new property but no improvements were made); Goldberg v. Commissioner, T.C. Memo 1997-74 (taxpayer loaned down payment to acquire new property); and 124 Front Street Inc. v. Commissioner, 65 T.C. 6. (1975), acq. 1976-2 C.B. 3 (advance to taxpayer to exercise option and acquire property was a bona fide loan, not boot).

In several cases and rulings, exchange funds held by an intermediary were used to pay for the construction. See PLR 9413006 (qualified intermediary released construction draws to contractor as work progressed on building). In PLR 9413006, a third-party seller owned the land and entered into a construction contract with an affiliate of the taxpayer which acted as the general contractor. See also Boise Cascade Corp., supra (buyer deposited funds with affiliate of taxpayer, which agreed to use the funds on the buyer’s behalf, for the next payments due under the construction contract); J.H. Baird Publishing Co., supra (accommodator sold taxpayer’s property, and sales proceeds deposited in escrow were used to pay for construction); Fredericks v. Commissioner, T.C. Memo 1994-27 (exchange funds were paid to construction company which was an affiliate of the taxpayer and applied to new construction).

If the taxpayer loans funds for the construction, the third party may pay off an amount of the loan to equalize exchange values. For example, assume that the total cost of the land and new building is $1,100,000, $900,000 is loaned for the construction, and $700,000 is the value of the old property. At the closing, the third party may pay down $500,000 of the construction loan leaving a balance of $400,000, so that the $700,000 net exchange value of the new property ($1,100,000 less $400,000 remaining loan) equals the $700,000 exchange value of the old property. See PLR 9149018.

In PLR 9149018, the taxpayer made a construction loan to the third-party buyer. The construction loan agreement included the following terms: (1) the loan was non-recourse; (2) advances bore interest at a variable rate; (3) the loan was secured by the buyer’s interest in the ground lease and the assignment of rents, construction contracts and insurance; (4) the loan proceeds were disbursed pursuant to the terms of a disbursement agreement to which the taxpayer, buyer and trustee were parties; (5) before advances were made, the buyer-borrower was required to spend an unspecified minimum amount of its own funds in connection with the project; (6) the unpaid principal and interest were payable 30 days after completion of the project; and (7) all accrued interest and principal became immediately due upon any default under any of the agreements relating to the project. Accordingly, it is important that any construction loan provided by the taxpayer or an affiliate bear interest, be secured, have a definite maturity date, and otherwise constitute bona fide indebtedness. Otherwise, the “loan” may be viewed as an equity or ownership interest in the property or improvements.

If independent financing is used for the construction, difficult issues may arise with respect to liability on the construction loan. Will the construction lender accept the third party as the borrower and under what conditions? Will the third party agree to these conditions? Can the taxpayer guarantee the loan? Can the taxpayer sign or co-sign the loan (which is secured by a deed of trust given by the third party)? If the taxpayer signs, co-signs or guarantees the loan, should the loan be treated in the same way as the taxpayer itself making the loan to the third party? Practitioners believe that the taxpayer should be able to guarantee the loan without jeopardizing the exchange. If the taxpayer signs or co-signs the loan, however, an issue arises as to who is really liable and paying for the construction. This, in turn, presents the issue of whether the taxpayer should be deemed to have an ownership interest in the property. If the taxpayer signs or co-signs the loan as an accommodation to the third party and the third party makes all of the loan payments and indemnifies the taxpayer from any liability, the loan liability should be allocated to the third party because it bears the economic risk of loss.

Can the construction contractor be the taxpayer or an affiliate? It appears that an affiliate of the taxpayer (who is in the construction business) may perform the construction services on behalf of the third party. See PLR 9413006 (general partner of taxpayer who held a license as a general contractor entered into construction contract with third-party land owner). See also Boise Cascade Corp., and Fredericks, supra. Such an arrangement presents issues of actual or constructive receipt of the exchange funds. PLR 9413006 held that an affiliated contractor may receive draws for its performance under the construction contract as work progresses on the building. See also PLR 200329021 which allowed reimbursement to a related party for certain planning costs out of exchange funds. Any disbursements should be made carefully, however, so as to avoid actual or constructive receipt of the exchange funds and disqualification of the entire exchange. The taxpayer itself should not be the contractor to reduce risks of actual or constructive receipt by the taxpayer. Although use of an affiliated contractor may not be prohibited, the safer procedure is to use an unrelated contractor.

Can the improved land be sold by a related party? Section 1031(f) severely limits exchanges involving related parties. If a related party sells the improved land in completion of the taxpayer’s exchange, Section 1031(f) will disqualify the exchange on either of the following grounds: (1) the related party did not hold any property received in the exchange for at least 2 years under Section 1031(f)(1); or (2) the transaction is structured to avoid the purposes of the related party rules and is taxable under Section 1031(f)(4). The problem under Section 1031(f) arises out of the sale and receipt of cash by the related party. In effect, the taxpayer is treated as receiving cash because the related party does so, and the exchange becomes taxable.

Can the land originally be owned by the taxpayer and then sold to a third party in anticipation of a future exchange? As discussed in detail above, this is very, very risky. If the taxpayer originally owns and sells the land pursuant to a prearranged transaction, the substance-over-form and step-transaction doctrines may apply. There is great risk that the transaction may be viewed as coming within DeCleene or Bloomington Coca-Cola Bottling Co, supra. See Rev. Proc. 2004-51. The much safer procedure is to have the third party acquire the land from an independent owner. Alternatively, the taxpayer might consider a long-term lease on land owned or leased to a related party (but not the taxpayer itself). See PLRs 200329021 and 200251008.

Who can be the third party? A third party must acquire and own the land on which the improvements are constructed. In reverse exchanges covered by Rev. Proc. 2000-37 (discussed below), the third party must meet the requirements applicable to an EAT. The third party cannot be a “disqualified person” if the safe harbors are intended to apply. The third party generally should not and cannot be the taxpayer’s agent. (An exception may be made if the third party is not a “disqualified person” and the safe harbors apply so as to allow an agency relationship under state law). The third party cannot be a person related to the taxpayer under Section 1031(f). The third party may not itself meet the requirements of a “qualified intermediary” under Treas. Reg. Section 1.1031(k)-1(g)(4) because it would not acquire and simultaneously transfer the replacement property. However, a QI may be used in such transactions to sell the taxpayer’s old property, use the proceeds to purchase the completed property from the third party (which may include an EAT), and transfer the completed property to the taxpayer. In general, the third party should be an independent person or entity who is not the taxpayer’s agent, nominee or partner. Accordingly, unless a safe harbor clearly applies, the third party should act for its own benefit and account and have some risk of loss as well as the ability to earn a profit.

What risks of ownership must the third party have prior to the exchange? In PLR 9149019, the third-party buyer of the taxpayer’s property entered into an exchange agreement with the taxpayer following Rev. Rul. 75-291. Instead of purchasing the land, the buyer entered into a ground lease with an unrelated land owner. The ground lease entitled the lessee (the buyer) to construct improvements and had a remaining term of 30 years or more to run upon consummation of the exchange. The ruling noted that the buyer had the following risks of ownership prior to the exchange: (1) the buyer had obligations under the exchange agreement, including the obligation to construct a building and meet the plans and specifications outlined by the taxpayer; (2) the buyer had obligations as a borrower and the taxpayer had rights and remedies as a lender with respect to the construction loan and financing (although the loan was non-recourse); (3) the buyer had to expend a minimum amount of its own funds prior to any disbursement from the loan; (4) the buyer was liable for any claims asserted with respect to the construction prior to the exchange; (5) the buyer was liable on the construction-related contracts; and (6) the buyer had obligations to perform under the ground lease. The ruling also noted that, except for its obligations under the construction loan and the exchange agreement, the taxpayer would not be responsible for any claims, obligations or causes of action arising out of the construction project prior to the exchange. Further, it was the intention of the taxpayer and buyer to create the relation of grantor and grantee with respect to the properties conveyed, and that nothing in the agreement shall be construed to make the parties partners, to create any agency or other similar relationship, or to make either party liable for any debts or obligations of the other party.

What kind of exchange should be used? A built-to-suit exchange may be a simultaneous, deferred or form of reverse exchange. Rev. Rul. 75-291 and PLR 9149018 illustrate a simultaneous exchange in which the third-party buyer of the taxpayer’s property acquires the land and constructs the improvements. The taxpayer then exchanges his old property for the completed new property in a future simultaneous exchange. This is similar to a so-called “reverse exchange” in which a third party acquires and holds the new property until the old property is sold. PLR 9413006 and J.H. Baird Publishing Co. illustrate a deferred exchange in which the taxpayer’s old property is sold, the proceeds are used to acquire the land and construct improvements, and the completed property is then transferred to the taxpayer. Unlike a deferred exchange, special property identification rules do not apply to a simultaneous or “reverse” build-to-suit exchange. Accordingly there is greater flexibility to change plans and ensure delivery of a completed building. But the taxpayer’s old property is not immediately sold in such transactions. The parties must find a way to finance the purchase of the land and construction of the improvements without use of the sale proceeds. The taxpayer might refinance the old property and loan the acquisition or construction funds to the third party. In general, care should be taken to avoid borrowing against the old property in anticipation of or immediately before an exchange. But if the taxpayer does not ultimately exit the series of transactions with any cash, arguably a pre-exchange refinancing solely for this purpose should not be treated as boot.

Special Rules for Deferred Exchanges. A deferred exchange for constructed property is subject to special identification and receipt requirements. Reg. Section 1.1031(k)-1(e) provides: (1) the replacement property must be identified within 45 days after the transfer of the taxpayer’s old property; (2) the identification notice must provide a legal description of the underlying land and a description of the construction of the improvements with “as much detail as is practicable” at the time of the identification; (3) for purposes of the 200% identification rule, the estimated fair market value upon completion should be used; (4) the replacement property must be received before the end of the 180-day exchange period or the due date, including extensions, of the taxpayer’s return for the year in which the old property is transferred; (5) the replacement property received by the taxpayer must be substantially the same property as identified but variations due to usual or typical production changes are not taken into account; (6) if “substantial changes” are made in the property to be constructed, the replacement property will not be considered to be substantially the same property as identified and the exchange will be taxable; (7) if construction is not completed at the time of receipt, the property must constitute “real property” under local law and must be substantially the same as the identified property if the work had been completed on the date of receipt; (8) construction performed after the replacement property is received by the taxpayer cannot be treated as part of the exchange; and (9) exchange funds spent on any post-acquisition improvements or repairs will be taxable to the taxpayer. While a deferred exchange provides a way to finance the purchase and construction, it is inflexible. The taxpayer cannot “substantially change” the plans and specifications after the end of the 45-day identification period. Further, the taxpayer assumes the risk of construction delays and may not receive a sufficiently completed building in the 180-day exchange period. For these reasons, a simultaneous or “reverse” exchange may be preferred using alternative financing.

Build-to-suit transactions involve difficult legal and practical considerations. The ultimate buyer and the original owner of the land are unlikely to want to assume the risks of ownership or construction. Use of an independent “middleman” may be required. Any third party will want to minimize personal liability and risk of loss on the transaction. A third party is likely to want a significant profit for participating in the transaction and assuming these risks. Accordingly, these transactions are complicated and expensive. Some exchange intermediaries create separate entities to act as the third party in such transactions. These entities are sometimes referred to as special purpose entities. Unless a safe harbor applies, if the entity does not put in any of its own funds, is indemnified against any loss and simply earns a fee, there is risk that the entity may be viewed as the taxpayer’s agent and the exchange may be disqualified. But see J.H. Baird Publishing Co. and Biggs, supra, indicating that even under these facts, the entity may not be the taxpayer’s agent. Thus, unless a safe harbor applies so as to avoid agency status, great care must be exercised in choosing the third party and structuring the transaction.

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