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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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