A leasehold exchange strategy is a form of 1031 exchange where the investor purchases land as a replacement property, or already owns land in which they would like to build a commercial property.

There are several reasons why an investor might choose to use a leasehold exchange. One is when the replacement property is in such bad shape that capital improvements are needed in order to make it profitable.

In the second case, a developer may find raw land and decide to build a property on it.

If they’re doing this as part of a 1031 exchange, they’ll need to make sure the new property’s value is equal or greater than the price of the property they are selling. Otherwise, they’ll be liable for what is termed “boot.”

And third, the investor may already own land that they wish to improve or build upon.

Why Investors Use A Leasehold Exchange

Firstly, the IRS doesn’t allow investors to own a replacement property at the time an exchange is executed.

Second, improvements on land owned by the investor don’t qualify the land or property as “like-kind” because any funds spent on construction aren’t considered real property in and of themselves.

The first problem is overcome by allowing a Qualified Exchange Accommodation Titleholder(EAT) to lease the land from the investor for a minimum 30-year lease. This must be done at least six months before the exchange.

The lease can be a straight 30 year lease, or it can be a lease with option to renew periods added on to the lease. In the latter case, the total number of years including the option to renewal periods must total a minimum of 30 years.

The EAT takes title of the replacement property through an LLC, and once the replacement property is acquired by the EAT, the investor has 180 days to complete construction and reach the target replacement value. If for some reason the investor anticipates not being able to finish the renovations before the 180 days are up, they can do a non-safe harbor Reverse Construction Leasehold Exchange.

When the 180 time period is nearly up, the EAT returns the improvements (not the property) to the original owner.

The original owner does not take ownership of the replacement property at this time, since the IRS requires the EAT to remain in possession of the replacement property for at least two years. At the end of two years the original owner takes possession of the property again.

Two Types of Leasehold Exchanges

There are two types of leasehold improvement exchanges: a forward improvement exchange, and a reverse build to suit.

In a forward leasehold improvement exchange (also called a forward build-to-suit), the investor first sells the property and places the capital in an exchange account.

Since the investor hasn’t yet acquired the replacement property, they will transfer the funds from the sale of the relinquished property to the EAT, who will then use it to purchase the property or land. The investor will also hand over the remainder of the funds in the exchange account to the EAT, who will use it to build or remodel the new property.

In the case of a reverse build-to-suit, the new property or land hasn’t yet been purchased, nor has the replacement property been sold.

Thus, the EAT will either receive a loan from the bank or from the investor themselves in order to buy the property. The investor then pays the EAT back once the exchange has ended and the they have sold the relinquished property.

A reverse build to suit can also be used where an investor already owns the land where they’d like to build a new property or make improvements.

A leasehold improvement exchange is a complex exchange that must be performed by experts with experience in this type of exchange. It’s also more expensive, with a relatively short time period in order to get things done.

Despite these difficulties, it can save the right investor tens of thousands of dollars in taxes if you make sure to seek the advice of an experienced 1031 professional.