The idea behind the 1031 exchange is to encourage investment into properties that you don’t already own. To that end, the IRS and Congress say to taxpayers “you can’t construct improvements on property that you already own” because they don’t view that as an “exchange.” So how do you tackle this potential 1031 exchange issue?
Third Party Seller
The first way to resolve this problem is to NOT construct the improvements on the land that you already own. Instead, go out and buy something from a third-party seller and construct improvements on that property through your intermediary (or exchange accommodation title-holder also referred to as an “EAT”). This is the simplest and cleanest way to do a Build-to-Suit Exchange.
Private Letter Ruling
There is however, a favorable authority (a private letter ruling) where a REIT had purchased property through a somewhat dissimilar but related subsidiary and then wanted to exchange into improvements upon the land owned by its dissimilar but somewhat related subsidiary using a long-term ground lease with an exchange accommodation title-holder. They constructed the improvements on new estate or separate interest in the property. So there are ways to fashion a build-to-suit on land owned by a somewhat related and dissimilar entity, but we need to make sure that it’s done properly and according to that authority (that private letter ruling), which is only really authoritative to the taxpayer that requested it. Nevertheless, this is illustrative of the IRS’ tax position.