1031 Exchange Preconstruction Contracts

The 1031 exchange and preconstruction contracts – these have two of the more popular tools used by real estate investors in recent years. The question is the same one asked by Reese’s when it looked at peanut butter and chocolate – are they two great things that are better together?

The answer with the resulting Reese’s Peanut butter Cups was a resounding yes. For the 1031 exchange and preconstruction contracts the answer is much less clear. Indeed, “use caution” seems to be the answer best applies. Let’s see why:

First, as with all 1031 exchanges, the same common-sense rules apply to transactions involving preconstruction contracts as with all other potential real estate transactions. Specifically this means: holding the contract to be sold for at least one year, using a qualified intermediary to handle the details, applying all the initial contract proceeds toward the replacement contract purchase, and purchasing or entering into replacement contracts of at least as much value as the sold contracts.

Beyond these basics, investors should enter into potential 1031 exchanges with preconstruction contracts with even more caution for several reasons. Let’s use the most common example: a condominium preconstruction contract. In this instance, investors need to bear in mind that the condominium developer's approval generally is required in order to sell a preconstruction contract. And, as a condition of approval, many developers require a share of the sale's profits. In addition, many lenders and financial institutions frown upon on numerous assignment contracts and prefer to see actual contract buyers.

The conservative and safe approach to using a 1031 exchange for preconstruction contract on a condominium is to obtain a tax opinion letter from a certified public accountant stating that the contract-for-contract exchange qualifies. Investors must be careful since, if the transaction is not handled appropriately, the IRS may raise a red flag if it suspects the contracts being exchanged are for flipping, not investing.

When attempting to navigate the path that leads to successful 1031 exchanges for preconstruction contracts, all real estate professionals and investors should seek legal and tax counsel on their transactions. In addition, exchangers should hire a well-experienced, independent qualified intermediary to ensure their 1031 transactions are managed according to IRS guidelines.