Rattikin Exchange Services, Inc. is pleased to provide you with information regarding the process involved in completing a Sec. 1031 tax-deferred exchange involving construction. If structured properly, a taxpayer can defer payment of capital gains taxes on the sale of business or investment property if he or she uses the proceeds to purchase replacement property and complete construction thereon, utilizing the services of a qualified intermediary and exchange accommodation titleholder.

Rattikin Exchange Services, Inc. provides qualified intermediary services to facilitate Sec. 1031 exchanges. The firm has handled well over $300,000,000 worth of exchanges on a local, state and national level. We offer our clients the highest degree of integrity, professionalism and efficiency, at a price well below that charged by the national exchange companies.

You have previously informed us that you may desire to complete the exchange by applying the proceeds from your sale of Relinquished Property towards the subsequent purchase of a replacement property and certain improvements to be constructed thereon. You should be aware that the IRS has strict regulations on a taxpayer’s ability to use exchange proceeds towards construction costs on replacement property. Basically, the IRS’ position is that a taxpayer cannot use a portion of the exchange funds to purchase replacement property in its own name, and subsequently spend the balance of the funds to construct improvements. Why? because the IRS views construction costs as payment for construction services and materials, rather than payment for real estate. As such, the payment for services does not constitute a like-kind exchange in connection with the sale of real estate.

To resolve this dilemma and facilitate the use of 1031 funds toward the construction of improvements on a target replacement property, the Internal Revenue Service issued procedural guidelines with respect to reverse and construction 1031 exchanges (IRS Revenue Procedure 2000-37, IRB 1 (September 15, 2000)). Pursuant to the procedures, and unlike most regular tax-free exchanges, title to the Property must be temporarily vested in the name of an Exchange Accommodation Titleholder, or EAT, who will hold title until the construction is completed. Basically, the property will be “parked” in the name of the EAT until construction is completed. The EAT should take title to the property, contract for and complete the desired construction and ultimately deed the improved property to you within the Exchange Period to complete your exchange.

To facilitate reverse and construction exchanges in which RESI is involved, we have formed a separate holding entity, named Texas Reverse Exchange Holding Company, L.L.C. (“Texas Reverse”), to act as EAT and hold title pending the completion of construction on the Replacement Property. The warranty deed and the Owner’s Title Policy issued in connection with this transaction shall reflect the grantee and insured as “Texas Reverse Exchange Holding Company, L.L.C., as Exchange Accommodation Titleholder for ________________________, as their interests may appear”, pursuant to Rate Rule P-63.

In order to initiate a construction exchange, you must first appoint Texas Reverse as Exchange Accommodation Titleholder, and execute several instruments required to document the exchange, including the following:

(1) Qualified Exchange Accommodation Agreement between the Purchaser and Texas Reverse, which outlines the nature of the exchange and the parties’ obligations thereunder;
(2) Original Assignment of Rights and Notification-Replacement Property, which assigns the Purchaser’s interest in the above Contract to Texas Reverse as Exchange Accommodation Titleholder;
(3) Construction Exchange Waiver and Release;

Basically, the Qualified Exchange Accommodation Agreement outlines the rights and obligations of you and Texas Reverse in connection with the exchange. The Assignment of Contract assigns your interest in the contract to Texas Reverse, which entitles Texas Reverse to purchase the property and obtain title thereto to hold pending the completion of construction. The Waiver and Release form is necessary to induce Texas Reverse to act as Exchange Accommodation Titleholder in the construction exchange process.

At closing, Texas Reverse will purchase the property with exchange proceeds transferred to Texas Reverse by RESI. Texas Reverse will hold the balance of the exchange proceeds in Texas Reverse’s escrow account pending completion of improvements to the property, making periodic draws as appropriate for payments to the contractor. Construction must be completed within the Exchange Period. Upon completion of the construction, or the end of the exchange period, whichever comes first, Texas Reverse will deed the improved property to you by Special Warranty Deed, thus completing the exchange. In effect, at that time you will be purchasing the improved property from Texas Reverse; the purchase price will be in the form of the exchange funds already paid by your intermediary, RESI, to Texas Reverse at the outset of the property purchase and construction.

In the event the property purchase and the construction cost will exceed the balance of your exchange proceeds, you will need to arrange for financing, either through you or a third party lender, to facilitate the EAT’s purchase of the Property. Since the EAT will be the actual purchaser, the loan will be in the EAT’s name, on a nonrecourse basis. Typically, you or your lender will require the following documents at closing, in addition to the above:

(1) Nonrecourse Real Estate Lien Note executed by the EAT;
(2) Nonrecourse Deed of Trust executed by the EAT;
(3) Guaranty Agreement to be executed by you;
(4) Lease Agreement executed by the EAT and you;
(5) Settlement Statement executed by the EAT, and approved by you;

Please verify with your lender which of the above documents will be required for this transaction.

I hope this letter explains to some extent the process involved in completing a tax deferred construction exchange.

Copyright 2009 Jeffrey A. Rattikin, all rights reserved