Advanced Construction Exchange Strategy: ACES for Commercial Developers

There are times when a developer may want to sell one of his properties and invest its proceeds in another he or she owns. In the past the IRS forbade 1031 exchanges in such cases; however, today there are specific, although narrow, paths that are accepted by the tax advisory community. The acceptable strategy is known as an Advanced Construction Exchange and has been upheld by private letter rulings and delineated in a Revenue Procedure.

A common misconception real estate developers have regarding Section 1031 is that developers are prohibited from using exchange proceeds to improve property that they already own. However, there are times when a developer may want to sell one of his properties and invest its proceeds in another he or she owns. In the past the IRS forbade 1031 exchanges in such cases; however, today there are specific, although narrow, paths that are accepted by the tax advisory community. The acceptable strategy is known as an Advanced Construction Exchange and has been upheld by private letter rulings and delineated in a Revenue Procedure.

The difference between the advanced construction exchange strategy and a standard tax deferred exchange is the type of property designated as replacement property. In a standard delayed exchange, the taxpayer identifies property held by a third party and uses exchange proceeds simply to purchase the new property. In an advanced construction exchange scenario, the taxpayer is attempting to close on relinquished property and utilize proceeds to improve property already owned by the same investment group. This is where the need to properly structure the exchange comes into play and wise tax counsel must be engaged, outside of your qualified intermediary who is prohibited by law from acting as a taxpayer’s fiduciary.

Specifically, one of the main obstacles the taxpayer has is Rev. Proc. 2004-51, which places restrictions on using replacement property owned by the taxpayer within six months of the exchange. The current solution is for the taxpayer to transfer the land that it wants to improve 180 days beforehand to a new taxable entity (not a pass-through entity), which in turn leases the land to the entity spending exchange proceeds pursuant to a long-term lease.

If completed correctly, with the right guidance and supervision, this transaction allows investors to greatly improve their own properties and consolidate their holdings. This flexibility can be extremely beneficial during recessions or other economic downtimes, when ancillary properties become less valuable and the need to improve core ones increases. Thus, the advanced construction exchange gives investors another tool to use in the marketplace.