For the real estate investor, an "improvement exchange"¹ provides flexibility to re-habilitate and modernize an aging but otherwise valuable structure, making the finished product "code compliant" through capital improvements and a better investment than other property readily available on the open market. For the business owner, the improvement exchange provides the opportunity to acquire vacant land and construct a building that meets the user's needs. This ability to make capital improvements, or build from scratch, all from tax deferred sales proceeds, provides the Exchangor with stellar opportunities.

Even before enactment of the regulations, courts granted taxpayers great latitude in improvement exchanges. For instance, in Coastal Terminals, supra, the court allowed the taxpayer to locate suitable replacement property and enter into negotiations for its purchase before the sale of her relinquished property.² A third-party can briefly hold replacement property for the taxpayer solely for the purpose of effectuating her exchange.³ The taxpayer can advance earnest money for purchase of the replacement property⁴ and can oversee construction of improvements on the land.⁵ The IRS itself has approved exchange transactions in which the replacement property was built to suit the taxpayer's requirements.⁶

Once the Exchangor takes title to the replacement property, the Exchange is complete and no improvements made to the property after the Exchange would be considered "like kind" property. By doing an improvement exchange, the Exchangor gets the delight of having her replacement property improved to her specifications while obtaining a greater tax deferral than if she had acquired the replacement property at a lower value and performed construction after taking title. The mechanisms available to the Exchangor for improving the replacement property or building from scratch on vacant land breakdown along three lines.

A. Seller Accommodated Improvement Exchange

One available option to the Exchangor is to convince the seller of the replacement property to first make her desired improvements and add the cost of those improvements to the sales price. The Exchangor would either obtain construction financing to lend to the seller, perhaps pledging title to the relinquished property as collateral for repayment, or reach an agreement with the seller to make the Exchangor's desired improvements at the seller's expense. Upon completion of the improvements, the seller would transfer title to the replacement property to the Exchangor. The colossal advantage to the Exchangor using this option is to effectively extend the 180-days required for transfer of title by delaying the transfer of the relinquished property until the replacement property is improved. This latter option would obviously require the cooperation of a highly-motivated seller! Rare is the circumstances involved in J.H. Baird Publishing Co., supra,⁷ where the Tax Court upheld a four-party exchange in which the Exchangor's realtor took title to her relinquished property and sold it on her behalf to a third-party, acquired desirable vacant land from yet another unrelated party using the Exchangor's sales proceeds, built improvements on it to the Exchangor's specifications and then, in completing the Exchange, transferred title to the Exchangor.

B. Contractor Accommodated Improvement Exchange

A second option to the Exchangor is to hire a developer to acquire title to the replacement property and build the improvements to the Exchangor's specifications during the Exchange Period. Once the value of the improvements, plus the cost of the land, equal or exceed the sales price of the relinquished property, the Exchangor may take title to the replacement property and achieve complete tax deferral treatment of the relinquished property proceeds, even if all of the improvements are not yet completed. The attractiveness of this approach, as opposed to a seller-completed improvement exchange is this: improvements to the replacement property do not have to be fully completed within the 180 day exchange period. Importantly, a certificate of occupancy is not required. Instead, the Exchangor can receive title to the replacement property as soon as she meets the "equal or up" rule. Moreover, the Exchangor can count improvements built and paid for during the 180-day exchange period, whether the project is complete or not. This option can be referred to as the pure "build to suit" arrangement. It may be less attractive to the Exchangor should the contractor exact a premium for the risk and costs associated with acquiring title to land on behalf of a third-party who may be unwilling or unable to ultimately close the end transaction. Another challenge for the Exchangor concerns proper identification of the improvements, since it would be impractical to identify a partially completed building.

C. Exchange Accommodation Titleholder Improvement Exchange

The more common approach includes the use of an Exchange Accommodation Titleholder ("EAT") to take and hold title to the replacement property while the improvements are constructed by the Exchangor or the Exchangor's general contractor. For years, the IRS has been savvy to the attempt to qualify improvements to the taxpayer's own replacement property. In the seminal case of Bloomington Coca-Cola Bottling Co., the Court affirmed the IRS position that the taxpayer's transaction should be treated as taxable when Bloomington Coca-Cola transferred its aging bottling plant, plus cash, to a general contractor in return for the construction of a new bottling plant according to the company's specifications but on land it already owned.⁸ In disregarding the form of the transaction, the Court held that Bloomington Coca-Cola had in substance merely exchanged its aging facility for build-to-suit construction services. The same fate awaited the taxpayer in DeCleene v. Commissioner.⁹ Here, the Court affirmed the IRS position that the taxpayer's transaction should be treated as taxable when DeCleene obtained title to replacement property on which to build a new truck repair shop but then quitclaimed his interest to a third party interested in what would have been his relinquished property. The third party later conveyed title to the replacement property along with a newly-constructed building suitable for DeCleene's repair business in exchange for the relinquished property. The Court found that these conveyances amounted to a taxable sale of the relinquished property to the third party since the third party never acquired beneficial ownership of the unimproved, replacement property.

A. Revenue Procedure 2000-37

The premise of Rev. Proc. 2000-37 is that the Exchangor cannot own both the relinquished and replacement properties at the same time. Thus, the replacement property must be "parked" with the EAT. The EAT is typically either a corporation or a limited liability company that is formed by the QI or another of its affiliates. The EAT and the QI can be one and the same party.

The Exchangor's excess sales proceeds, plus additional monies from construction financing, if necessary, are used to complete the improvements. Upon the earlier of (a) the expenditure of all the sales proceeds, (b) the completion of the improvements, or (c) the end of the Exchange Period, the EAT then transfers the improved replacement property to the Exchangor. As between the "pure" build-to-suit arrangement and the accommodator approach, the Exchangor is likely to prefer the latter, since she would not pay a premium to the "build to suit" contractor, and again be able to take title to the replacement property even if the improvements are not fully completed within the 180 days. Again, the regulations do not require the Exchangor to obtain a certificate of occupancy within the Exchange period; instead, the Exchangor can receive title to the replacement property as soon as she meets the "equal or up" rule.

B. Revenue Procedure 2004-51

While both Bloomington Coca-Cola Bottling and DeCleene make clear that, in the tax environment preceding Rev. Proc. 2000-37 and its validation of the "parking arrangement," the Exchangor does not obtain tax-deferral treatment of an improvement exchange where the improvements take place on land already owned by the Exchangor. "A taxpayer cannot effectuate a tax deferred exchange with itself."¹⁰ In the post-revenue procedure environment of 2000-37, some Exchangors and their advisors found a loophole to this general prohibition. To avoid the result of these cases, Exchangors have either transferred or leased the land on which the improvements were to be constructed to the EAT in the parking arrangement clearly set forth by IRS. Rev. Proc. 2000-37 is silent on the issue of the prior ownership of the parked property. Crafty Exchangors figured out that they could transfer title to their own real property on which they want to build improvements by first quitclaiming their interests to the EAT who would then make the desired improvements and in turn transfer title back to the Exchangor, all the while meeting the requirements of the revenue procedure.

In 2004, IRS closed the door on this practice. In issuing Revenue Procedure 2004-51, IRS specifically ruled that the "safe harbor" protection dictated in Revenue Procedure 2000-37 "does not apply to replacement property held in a QEAA if the property is owned by the taxpayer within the 180-day period ending on the date of transfer of qualified indicia of ownership of the property to an exchange accommodation titleholder."¹¹ Specifically, Rev. Proc. 2004-51 modifies sections 1 and 4 "to provide that Rev. Proc. 2000-37 does not apply if the taxpayer owns the property intended to qualify as replacement property before initiating a qualified exchange accommodation arrangement (QEAA)."¹² The revenue procedure clearly reinforces the IRS position articulated in Bloomington Coca-Cola Bottling and again in DeCleene: that is, the taxpayer cannot make improvements to land already owned by the taxpayer.

The standard for identification of improvements is imprecise. Treas. Reg. §1.1031(k)-1(e) (2) states in part "and as much detail is provided regarding construction of the improvements as is practicable at the time the identification is made." The Exchangor makes proper identification if she has developed blueprints or construction drawings by the 45th day after parking the property. An Exchangor only reaches this level of sophistication with careful pre-exchange planning involving not only her architect and contractor but also the seller of her replacement property. A "Scope of Work" document could be useful in this context.

The Exchangor should also describe if possible the degree to which the improvements will be completed as of the end of the Exchange Period. Exchangors should use the 3-property rule to describe the same land three times but with varying degrees of completion. If the Exchangor describes a fully-constructed replacement property, but acquires title to it when it is only half completed, IRS may take the position that the replacement property was not properly identified and invalidate the exchange. Minor alterations, such as installation of a fence, do not impact the identification.¹³ While common sense would also suggest that the IRS would allow for construction changes to the project, particularly if contracted on a "fast track" protocol, the general principal requires that the property received by the Exchangor be substantially the same as the property identified.

While the improvements need not be completed within the Exchange Period, the value of any portion of the improvements not completed within this time frame do not qualify as replacement property; that is, post-closing improvements made to the replacement property are not like kind property.¹⁴ Due to the potential for construction delays, and the difficulties encountered by contractors in northern climates, the typical improvement exchange may preclude use of all excess sales proceeds within the 180-day period.¹⁵ While capital improvements made to the parked property after transfer of it by the EAT to the Exchangor will surely add to the tax basis of the property, such improvements do not count in determining if the tax exposure has been deferred under the exchange transaction. In other words, if the EAT transfers the replacement property to the Exchangor at or before the end of the Exchange Period but when the construction is not yet complete, the fair market value of the replacement property for exchange purposes will only include the value of the land plus the improvements that were actually constructed on the property as of the date of transfer.

The regulations specifically prohibit inclusion of "pre-paid" items, such as architectural, engineering and construction management fees, or raw materials. In this sense, qualifying improvements must be integrated into the standing structure or mechanical systems and not simply pre-paid or delivered on site. As to pre-payment to the general contractor, these excess sales proceeds are considered "boot," since improvements to be built in the future (i.e., after expiration of the Exchange Period) are not like-kind real property.¹⁶ As to on-site delivery of raw materials such as structural steel, doors and windows or plumbing pipe and fixtures, or mechanical systems such as HVAC or security devices, all such materials do not qualify as improvements. While this requirement may seem obvious under the state law of "fixtures" (the defining moment when personal property transforms into real property)¹⁷, even the most sophisticated of Exchangors sometimes fail to avoid this trap.¹⁸

The rule against pre-payment of construction costs within the 1031 Exchange does not fully address the realities of the marketplace, however. Common to many if not most construction contracts, the concept of "substantial completion" guides the right of the contractor to payment even if not all of their scopes of work tasks are completed to a finished product.¹⁹ In common parlance, substantial completion can be understood as that moment when improvements, while not perfect, allow the owner actual or beneficial use of them.²⁰ The contractor reaches a point of "substantial completion" only when "punch list" items remain for the contractor to change or fix.²¹

If the Exchangor's contractor reaches the threshold of "substantial completion" as defined within the construction industry, and only "punch list" items remain, could one argue that payment can be made at this point and still qualify for tax-deferral treatment? While clearly a pre-payment to be ignored for exchange purposes under the regulations, such payment clauses are a market reality. The practice seems consistent with the interpretation of the regulations as not requiring a certificate of occupancy to be issued to the Exchangor prior to the expiration of the Exchange Period. In this light, the Exchangor should carefully analyze whether her improvements are at such a point of construction that the "substantial completion" clause in her construction contract is triggered, requiring payment to the contractor. This analysis may help better fulfill her tax-deferral objectives without running afoul of the regulations.

In determining the extent to which the Exchangor has "traded up" in value in an improvement exchange, it is important to understand the different tax treatment, and therefore definitions of, "repairs" versus "improvements." Repairs are deductible as expenses for the tax year in which they are made, while improvements are capitalized and then depreciated over the life of the asset. Properties under development by EATs are generally subject to the uniform capitalization rules outlined in Code Section 263A and its regulations²² even if the Exchangor or her affiliate constructs the improvements. The regulations list the costs that should be capitalized.²³ For any construction items not listed there, the Exchangor is on her own in determining such other costs that are directly related to the construction of the improvements. Help may be found in the regulations making clear that "repairs" keep property in good working condition but do not "materially add" to its value or "appreciably prolong" its life.²⁴ Likewise, "improvements" add value, prolong life by arresting deterioration and/or modify to new uses the property in question.²⁵

The line between a repair that keeps the property in good working condition and an improvement that "arrests deterioration" may be a very fine one. While "soft costs" are difficult to account for in the improvement exchange, the regulations do allow the Exchangor to make a "reasonable allocation" of such costs to construction activities.²⁶ Nonetheless, IRS issued Notice 2004-6 by which they solicited comments on what improvements "materially increase the value of property, substantially prolong the useful life of property, or adapt property to a new or different use."²⁷ The 15 questions posed in Notice 2004-06 belie the government's own uncertainty of the differences between repairs and improvements. Therefore, the Exchangor should be cautioned to act fairly in her determination of whether any expenditure appreciably prolongs the property's useful life or materially increases its market value. In the absence of the affirmative for either analysis, the IRS will likely determine that the expenditure is considered routine maintenance or repair work to be expensed and deducted in the tax year in which it was incurred. As such, the expenditure would not qualify for tax-deferral treatment. In short, only excess sales proceeds used for capital improvements count toward the Exchangor's tax deferral.

Financing of build-to-suit transactions are generally complex in that the EAT is treated as the borrower under the purchase money loan documents. The EAT requires the lender to agree to a non- recourse loan structure, since the EAT is unwilling to accept any personal liability for the transaction, although Rev. Proc. 2000-37 allows the Exchangor to give her personal guaranty of the loan.²⁸ The lender is therefore denied an opportunity to collect any deficiency from the EAT in the event of default and foreclosure and instead must rely upon the Exchangor's guaranty for satisfaction. The loan must be pre-payable and, in the event the lender takes a mortgage or deed of trust against the relinquished property as additional security for the loan to the EAT, must permit the Exchangor to dispose of the relinquished property free and clear of the security agreement once it is sold to a third party. The loan documents must also include a transfer provision allowing the EAT to convey title to the replacement property to the Exchangor on or before expiration of the Exchange Period, since Code Section 1031 mandates this result. A "due on sale clause" triggered by such transfer makes little sense in this context and would actually serve to defeat the purposes of the exchange.²⁹

The fact that the EAT acts as "borrower" under the loan documents and "owns" the replacement property creates heartache for many institutional and nearly all community banks. The loan structure can also prove difficult for the Exchangor with few assets by which to finance the acquisition and development of the replacement property without the benefit of her equity in the relinquished property. However, this structure is similar to that used in traditional build-to-suit arrangements in which financing is accomplished through "synthetic leases."³⁰ Here, the benefits and risks of owning and operating the property are shifted from a special purpose entity ("SPE") to the taxpayer, as lessee. The SPE is treated as the borrower, purchaser of the property and acts as lessor under a triple-net operating lease with the taxpayer (i.e., the tenant under this structure).³¹

More specifically, the SPE, customarily a pass-through entity (such as a business trust, special-purpose corporation, limited partnership, or limited liability company) takes title to the property, either directly or by assignment of the purchase contract, constructs the building, and leases the property to the lessee-corporate user or its subsidiary. A synthetic lease of real estate using an SPE commonly requires rental payments from the lessee equal to the sum of the interest on the SPE's debt plus a return on the SPE's equity investment, with no amortization of the debt's principal or return of its equity during the term of the lease. The SPE, acting as lessor, obtains financing for the transaction with a small equity investment in the project (usually three percent) and debt financing for the balance. The debt financing generally is in the form of commercial paper or commercial bank debt, often in combination with mortgage financing.³² The "synthetic lease" is a common form of lending and should provide a parallel structure for the lender in an improvement exchange transaction.

Now that the regulations and revenue procedures of late have clearly articulated a road map for improvement exchanges, it is much easier for the Exchangor to plan for construction of new improvements to the replacement property. If the Exchangor complies carefully with the safe harbor rules, she can enjoy the presumptions of Rev. Proc. 2000-37 in fashioning her improvement exchange to maximize tax-deferral of her relinquished property sales proceeds. Open questions regarding "qualifying improvements" (repairs v. improvements) and "substantial completion" payments remain unresolved, however. Of course, the time pressure to complete significant improvements to land within the Exchange Period remains an immovable obstacle to the usefulness of the improvement exchange, particularly in climates that allow for an already abbreviated construction season.

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