Taking 1031 Exchange Funds Into a Ground-Up Development

Your developer client wants to take 1031 money as an investment for a ground-up project (new construction). If you are not in an Opportunity Zone, there is only one path that works. You must convey a portion of the fee interest to the 1031 investor and paper the co-ownership with a tenancy-in-common agreement (a “TIC Agreement”) built to a very particular revenue procedure. This piece is written from the sponsor’s side. It works through whether that capital can be accepted at all, how much of it can actually be sheltered, and where the recognized structure collides with the way developers really run deals: the promoted waterfall, the general contract, and the construction loan guaranty and borrower.

The threshold obstacle is statutory. Section 1031 defers gain only on an exchange of real property for like-kind real property, and it expressly excludes interests in a partnership. So the exchanger cannot simply subscribe for a limited partnership or membership interest in your venture. To defer, the exchanger’s proceeds have to land on direct real property, which for a co-invested development means an undivided fractional interest in the fee.

Scope. This piece addresses the federal like-kind-exchange structuring question only, and it assumes the project is not located in a Qualified Opportunity Zone. It does not cover Opportunity Zone deferral, the securities-law treatment of the raise, state transfer or documentary taxes, UBTI or ERISA concerns for tax-exempt investors, or the mechanics of the exchanger’s relinquished-property sale and qualified-intermediary process.

The short answer

The direct route is barred: a partnership or LLC interest is not like-kind property. Tenancy-in-common co-ownership under Revenue Procedure 2002-22 is the recognized path, but it sits in direct tension with core developer economics and with what a construction lender will accept. The held-for-investment requirement and the 45/180-day clock frequently cap how much of the exchanger’s check can be sheltered at all. And a Delaware statutory trust, the usual passive 1031 vehicle, cannot hold a ground-up development. What follows is why each of those is true and how a sponsor can structure around them.

1. Why the direct path fails: the partnership-interest bar

Section 1031(a)(1) defers gain on the exchange of real property held for productive use in a trade or business or for investment, when it is exchanged for like-kind real property. Before the 2017 Tax Cuts and Jobs Act, Section 1031(a)(2) contained a list of property that did not qualify, and it expressly excluded interests in a partnership, whether general or limited. The Tax Cuts and Jobs Act rewrote the section to reach real property only and removed that list as unnecessary. The result is the same and is now cleaner. A partnership interest is not real property, so it cannot be like-kind replacement property under Section 1031(a)(1), and the exchanger cannot defer by taking an equity interest in the venture.

The practical consequence is that the exchanger cannot invest by taking an equity interest in the deal entity. A limited partner interest in the joint venture is barred. An interest in an upstream investor fund is barred for the same reason. A single-member LLC interest is the one exception that helps, because a wholly owned LLC is disregarded for federal tax purposes, so its sole member is treated as owning the underlying real property directly. That is why the recognized structure puts the exchanger into a direct undivided fee interest, which the exchanger may hold either in its own name or through its own disregarded single-member LLC.

2. Two threshold gates decide whether 1031 is even available

Before structure, two gates determine whether the exchanger can use Section 1031 at all on this asset. Both are easy to miss when the focus is on the co-ownership paperwork.

Held for investment, not held for sale. Section 1031(a)(1) reaches only property held for productive use in a trade or business or for investment, and Section 1031(a)(2) excludes real property held primarily for sale, which is dealer inventory. Such property does not qualify as either relinquished or replacement property. A build-to-rent project that the co-owners intend to hold and operate for rental income fits. A for-sale product, such as a condominium project or a lot subdivision built to be sold off, is inventory in the developer’s hands and cannot serve as replacement property for the exchanger at all. The line turns on the holding purpose, and “primarily” means of first importance, not merely substantial. Malat v. Riddell, 383 U.S. 569 (1966). Because a ground-up developer’s ordinary business is building to sell, the intent to hold for investment has to be real and documented, not a label.

The 45/180-day clock against a multi-year build. In a deferred exchange, the exchanger must identify replacement property within 45 days of transferring the relinquished property and must receive the replacement property within 180 days. Section 1031(a)(3). The gain deferred is limited to the value of the like-kind real property the exchanger actually receives inside that window. On a development that takes two or three years to deliver, the only real property in existence to receive within 180 days is the land, plus whatever vertical improvement has actually been built by day 180.

The improvement, or build-to-suit, exchange under Revenue Procedure 2000-37, as modified by Revenue Procedure 2004-51, does not rescue a long build. In that structure an exchange accommodation titleholder parks title and makes improvements, and the exchanger then receives the improved property. But the improvements only count toward the exchange to the extent they are completed and received within the same 180 days. A three-year construction schedule cannot be compressed into that window. The practical result is that a single exchanger usually cannot shelter its entire intended contribution. It can defer gain up to roughly the value of the land it takes at closing, plus any improvements in place by day 180, and no more. Modeling that cap before anyone commits is the point at which many sponsors find the exchanger’s 1031-eligible dollars are far smaller than the check they intended to raise.

3. The workable structure: tenancy-in-common co-ownership

The recognized way to put 1031 proceeds into a co-invested real estate deal is a tenancy in common. The exchanger takes an undivided fractional interest in the fee, held directly or through a disregarded single-member LLC, alongside the sponsor’s own ownership of the balance. A TIC Agreement governs the relationship, and the co-owners typically elect out of the partnership rules under Section 761(a) so the arrangement is not treated as a partnership for tax purposes.

The reference point is Revenue Procedure 2002-22, which sets out the conditions the IRS uses to decide whether it will issue a ruling that an undivided fractional interest is an interest in real property rather than an interest in a business entity. The conditions, roughly fifteen in number, include the following, which are the ones that matter most to a developer:

• Co-ownership, capped at 35. Each co-owner must hold title as a tenant in common under local law, and there can be no more than 35 co-owners. A husband and wife count as one, and a disregarded entity is looked through to its owner.
• No entity conduct. The co-owners cannot file a partnership return, hold themselves out as a partnership, or conduct business under a common name.
• Unanimity on major decisions. Sale of the property, any lease of the whole or a part, and the creation or renegotiation of debt secured by a blanket lien require the unanimous consent of all co-owners. Lesser decisions may be made by co-owners holding more than 50 percent of the undivided interests.
• Free transferability and partition. Each co-owner generally must be able to transfer, partition, and encumber its own undivided interest without the approval of the others, subject to limited and customary lender or co-owner rights of first refusal.
• Pro-rata sharing. Sale proceeds, the debt secured by a blanket lien, the revenues, and the costs must all be shared by the co-owners in proportion to their undivided interests.
• Annual, arm’s-length management. Any management or brokerage agreement must be renewable no less often than annually, must be at arm’s length, and the management fee cannot be based on the income or profits of the property.
• FMV payments to the sponsor. Amounts paid to the sponsor for acquiring the co-ownership interest, and any fees, must reflect fair market value and cannot depend on the income or profits from the property.

Two cautions about the revenue procedure are essential and are frequently overstated in marketing materials. First, Revenue Procedure 2002-22 is not a substantive safe harbor. It tells taxpayers the conditions under which the IRS will consider a ruling request. The IRS states expressly that it will not rule that an arrangement is a tenancy in common merely because it satisfies the conditions, and that satisfying them is not a guarantee of the result. Second, whether a co-ownership is a tenancy in common or a partnership is ultimately a question of fact under general tax principles. Revenue Ruling 75-374 is the classic statement: a co-tenancy that stays within customary ownership and maintenance activities is not a partnership, but once the co-owners furnish services and conduct an active business through the property, it crosses into partnership territory. That fact-and-circumstances test governs whether or not a ruling is sought, and it is where a development deal gets into trouble.

4. Where the safe harbor collides with a developer’s deal

Every instinct a developer has about how to run a project pushes against the TIC conditions. There are four principal friction points.

A promoted waterfall against pro-rata sharing. The economic engine of a sponsor’s deal is the promote: return of capital, then a preferred return to investors, then a disproportionate share of the upside to the sponsor. The TIC conditions require that profits, losses, sale proceeds, and debt all be shared strictly in proportion to undivided interests. A promote is by definition a disproportionate share of profit, and it is one of the strongest indicators that an arrangement is a partnership rather than a co-tenancy. A standard promoted waterfall on the exchanger’s tranche is therefore inconsistent with the safe harbor’s economic-sharing conditions.

Sponsor control against unanimity. A developer expects to control the asset: to decide when to sell, how to finance, whom to hire. The TIC conditions hand the exchanger a veto over exactly those decisions, because sale, blanket-lien financing, and leasing require unanimous consent, and the management agreement has to be renewed annually. A durable, unilateral sponsor control right is inconsistent with that veto.

Active development against “no business beyond customary maintenance.” This is the deepest problem. The TIC conditions confine the co-owners’ activities to those customarily performed in connection with the maintenance and repair of rental real property, the same line Revenue Ruling 75-374 draws. Ground-up construction is not maintenance of rental property. It is an active development business, and the more of that activity runs through the co-ownership, the more the arrangement looks like a partnership carrying on a trade or business. Development activity is itself the classification risk.

Construction lender resistance. Construction lenders are built to underwrite a single, creditworthy borrower with a single guarantor and a clean lien. A TIC gives them multiple owners of undivided interests, each with a statutory right to partition and to transfer its interest, and a blanket lien that cannot be refinanced without unanimous consent. Lenders resist multiple borrowers and multiple guaranties, and they resist the partition and transfer rights the safe harbor requires. Getting a construction loan onto TIC-held collateral is a negotiation in its own right.

If the arrangement is recharacterized as a partnership, the exchanger never received “real property.” The exchange fails, the deferred gain is recognized, and interest and penalties follow. That is the risk that sits behind all four friction points.

5. The four operational questions, worked through

The friction points above are where a sponsor’s deal actually breaks. Here is how each of the practical questions gets resolved, and where it cannot be.

Who is the borrower on the construction loan? In a tenancy in common there is no single entity to borrow. Each co-owner owns an undivided fractional fee interest, and a lender taking a blanket lien on the whole property will require every co-owner to be a co-borrower and to sign the note. That is consistent with the TIC condition that debt secured by a blanket lien be shared pro rata: both the sponsor’s ownership and the exchanger’s undivided interest secure the loan, and each co-owner is liable in proportion to its interest. What does not work is making the exchanger a borrower on more than its proportionate share, because disproportionate debt is another partnership indicator. The exchanger’s lender also cannot be a person related to the sponsor or manager, which the safe harbor prohibits. Expect the lender to require a co-ownership and subordination arrangement, lender consent rights layered on top of the TIC Agreement, and estoppel-style protections against a co-owner exercising partition mid-construction.

Who guarantees the construction loan? Construction lenders require completion and repayment guaranties, plus the usual non-recourse carve-out, or “bad boy,” guaranty, from a creditworthy sponsor and its principals. A passive 1031 investor generally will not, and as a structuring matter should not, guarantee beyond its own interest. It came in for a passive, deferred investment, and loading disproportionate recourse onto one co-owner distorts the pro-rata debt sharing the safe harbor wants. The workable answer is that the sponsor and its principals give the completion and carve-out guaranties, and the sponsor is compensated for that risk through an arm’s-length, fair-market guaranty fee that is fixed or market-referenced rather than tied to the property’s income or profits. A guaranty fee measured by profit reintroduces the promote problem and looks like a partnership distribution. Fixed compensation for a real service is consistent with the conditions on payments to the sponsor.

How do you sign the general contract? The general contractor needs an owner counterparty, and in a TIC there is no entity to be that counterparty. Either every co-owner signs the construction contract as owner, or the sponsor signs on the co-ownership’s behalf under a management or development agreement. Both routes run straight into the “no business beyond customary maintenance” condition, because engaging a general contractor to erect a building is active development, not maintenance of rental property, and the annually renewable management agreement is a thin vehicle to carry full development authority. The most defensible approach narrows what actually happens inside the co-ownership. The exchanger takes its undivided interest in the land, and the vertical development is executed under a development agreement with the sponsor acting as developer for an arm’s-length, fair-market development fee, with the co-owners as owners of record. That keeps the sponsor’s construction role in a service contract rather than converting the co-ownership into a development partnership. It reduces the risk but does not eliminate it, because active construction on co-owned land is exactly the fact pattern that pushes a co-tenancy toward partnership treatment, and no published authority approves a full ground-up build inside a Revenue Procedure 2002-22 co-ownership.

How do you honor the waterfall? You largely cannot, at least not on the 1031 dollars, and this is the point to be candid with the client about. The exchanger’s TIC economics have to stay pro-rata. The sponsor’s promote has to be earned somewhere other than a disproportionate share of the co-ownership’s profit. In practice that means two moves. First, keep the exchanger’s undivided interest strictly pro-rata as to profit, loss, and proceeds. Second, move the sponsor’s economics into arm’s-length fees for real services (a development fee, a construction-management fee, a guaranty fee), each at fair market value and none keyed to income or profits, rather than a carried interest on the exchanger’s capital. A promote riding on the 1031 tranche is inconsistent with the safe harbor’s pro-rata sharing conditions, so a deal that genuinely requires a promoted return on every dollar cannot accommodate 1031 capital in this structure; the promote is confined to the non-1031 equity.

And if the project struggles and needs more capital? This is the scenario that exposes the structure most. A tenancy in common has no capital-call machinery like an operating agreement’s. Additional capital has to come in pro rata, and if the exchanger cannot or will not fund its share, the usual developer remedies (dilution of the non-contributing owner, punitive member loans, a shifting promote) are precisely the disproportionate-economics and active-business features that signal a partnership. A blanket-lien workout or refinance needs the exchanger’s unanimous consent. So the very tools a sponsor relies on to rescue a distressed project are the tools most likely to collapse the co-ownership into a partnership and unwind the exchange. Sizing reserves and contingency up front, rather than solving them by later capital calls, is the trade-off the structure imposes.

6. Why a DST does not fit ground-up

The usual way to give a 1031 investor a truly passive real estate interest is a Delaware statutory trust. Revenue Ruling 2004-86 holds that a beneficial interest in a properly structured DST is treated as a direct interest in the trust’s real estate, so it qualifies as replacement property, and it avoids the 35-owner cap and the unanimity mechanics of a TIC. But the same ruling imposes a set of prohibitions on the trustee, commonly called the “seven deadly sins,” that make a DST incompatible with development. The trustee cannot accept new capital once the offering closes. It cannot refinance or borrow new money. It cannot reinvest sale proceeds. Its capital expenditures are limited to normal repair and maintenance, minor non-structural improvements, and improvements required by law. It cannot enter into new leases or renegotiate existing ones, outside a master-lease structure. Cash must be distributed currently, and reserves can be held only in short-term obligations.

A ground-up development needs the opposite of all of that. It needs construction financing, ongoing capital, major construction, and active leasing. A DST that did any of those things would lose its status and be treated as a business entity, defeating the exchange. DSTs are the right tool for stabilized, financed-out, net-leased assets, not for new construction. This is why the TIC, for all its friction, is the only recognized fit for a development.

7. Structuring options for the sponsor

Reduced to the choices a sponsor actually has:

• TIC on the land at closing, with the promote and control dialed back on the exchanger’s tranche. Put the exchanger into an undivided fee interest in the land, keep its economics pro-rata, take sponsor compensation as arm’s-length fees, and negotiate the lender arrangements described above.
• Split the raise. Size the 1031 slice to what can actually be sheltered, roughly land value plus any day-180 improvements, and take it through a TIC. Raise the balance as ordinary equity from non-1031 investors in the joint venture entity, where a normal promoted waterfall and full sponsor control live undisturbed.
• Compensate the sponsor with fees, not a promote, on the 1031 capital. Development, construction-management, and guaranty fees at fair market value, none tied to income or profits, keep the sponsor paid for real services without the disproportionate-profit feature that signals a partnership.
• Decline 1031 treatment where the gates or the economics do not square. If the asset is for-sale product, if the holding purpose is really resale, if the 45/180 cap shelters too little to matter, or if the deal cannot function without a promote on every dollar, the cleaner answer may be to take the investor’s money as ordinary taxable equity or to wait until there is a stabilized asset the investor can exchange into.

8. Comparison of the routes

	Direct LP/LLC interest	Tenancy in common	Delaware statutory trust
Qualifies for 1031 deferral?	No. A partnership interest is excluded.	Yes, if respected as co-ownership of real property.	Yes. Beneficial interest treated as direct real estate.
Works for ground-up construction?	Not applicable.	Only with significant strain, and active development is itself the classification risk.	No. New capital, financing, and major construction are prohibited.
Promote or waterfall compatible?	Fully, but no deferral.	No. Sharing must be pro-rata; promote endangers the classification.	No. Economics are fixed and passive.
Capital calls and construction compatible?	Yes, but no deferral.	Poorly. Non-pro-rata capital calls and workout remedies signal a partnership.	No. No new capital or refinancing permitted.
Lender friction	Normal single-borrower financing.	High. Multiple borrowers, partition and transfer rights, unanimity to refinance.	Moderate. Financing must be in place at closing and cannot be renegotiated.
Governing authority	I.R.C. § 1031(a)(1) (real property only).	Rev. Proc. 2002-22; Rev. Rul. 75-374.	Rev. Rul. 2004-86.

9. Competing authority and open questions

Several points are unsettled and should be flagged for any client relying on this structure.

The status of Revenue Procedure 2002-22 is the largest. It is a set of guidelines for advance rulings, not a substantive safe harbor, and the IRS has said compliance does not guarantee tenancy-in-common treatment. Conversely, failing one condition does not automatically make the arrangement a partnership. The controlling question remains the fact-and-circumstances test of Revenue Ruling 75-374 and the general entity-classification principles. Reasonable practitioners take different views on how much development activity a co-ownership can tolerate before it becomes a partnership, and there is no case or ruling directly blessing a full ground-up build inside a 2002-22 co-ownership.

The treatment of a sponsor’s promoted return inside a co-ownership is similarly untested at the edges. Recharacterizing a profit-based fee as a disguised partnership distribution is a known risk, but the line between fair-market service compensation and a disguised profits interest is a matter of judgment.

The build-to-suit exchange under Revenue Procedure 2000-37 and Revenue Procedure 2004-51 has real but bounded utility. It can capture improvements built within the 180-day window through a parking arrangement, but it cannot extend the statutory clock, and Revenue Procedure 2004-51 limited the use of property the taxpayer already owns. Whether and how far an improvement exchange can be combined with a TIC on a development is not cleanly settled.

The bottom line

For a sponsor deciding whether to accept 1031 money into a ground-up deal outside an Opportunity Zone, the analysis reduces to a few controlling facts. The direct route is barred, because a partnership or LLC interest is not like-kind property. The tenancy in common under Revenue Procedure 2002-22 is the only recognized path, but it is a set of ruling guidelines rather than a guarantee, and the classification ultimately turns on the fact-and-circumstances test of Revenue Ruling 75-374. The held-for-investment requirement excludes for-sale product entirely, and the 45/180-day clock usually caps the exchanger’s sheltered contribution at roughly land value plus any improvements completed within 180 days, which is often far less than the sponsor wants to raise. A DST, the usual passive vehicle, cannot hold a development because of the Revenue Ruling 2004-86 restrictions on new capital, financing, and construction.

The structure that survives keeps the exchanger’s undivided interest strictly pro-rata, moves the sponsor’s economics into arm’s-length fees rather than a promote on the 1031 dollars, gives the guaranties from the sponsor rather than the passive investor, and confines active development to a service contract rather than the co-ownership itself. Even then, the two scenarios that most define a development deal, a promoted upside and a capital call into a struggling project, are the two the structure tolerates least. Sizing the 1031 tranche to what can actually be sheltered, running the promote and control on the non-1031 equity, and pricing the fragility of the co-ownership before taking the money are the choices the structure imposes on a sponsor working within it.

Citations

Cases

• Malat v. Riddell, 383 U.S. 569 (1966) (per curiam) (property “held primarily for sale” turns on holding purpose; “primarily” means of first importance, not merely substantial).

Statutes

• I.R.C. § 1031(a)(1) (deferral of gain on exchange of real property held for productive use or investment for like-kind real property; a partnership interest is not real property and therefore is not eligible replacement property).
• I.R.C. § 1031(a)(2) (exception for real property held primarily for sale).
• I.R.C. § 1031(a)(3) (45-day identification and 180-day receipt requirements for deferred exchanges).
• Tax Cuts and Jobs Act, Pub. L. No. 115-97, § 13303, 131 Stat. 2054 (2017) (limiting § 1031 to real property effective for exchanges after Dec. 31, 2017, and eliminating the former § 1031(a)(2) exclusion list that had expressly barred partnership interests under prior § 1031(a)(2)(D)).
• I.R.C. § 761(a) (election to be excluded from the partnership provisions of subchapter K).

Administrative Authority

• Rev. Proc. 2002-22, 2002-1 C.B. 733 (conditions under which the IRS will consider a ruling request that an undivided fractional interest in real property is not an interest in a business entity).
• Rev. Rul. 2004-86, 2004-2 C.B. 191 (beneficial interest in a Delaware statutory trust treated as a direct interest in the trust’s real property for § 1031; trustee restrictions).
• Rev. Rul. 75-374, 1975-2 C.B. 261 (co-tenancy furnishing only customary services is not a partnership; active business through the property crosses into partnership treatment).
• Rev. Proc. 2000-37, 2000-2 C.B. 308 (safe harbor for parking arrangements in improvement/build-to-suit exchanges using an exchange accommodation titleholder).
• Rev. Proc. 2004-51, 2004-2 C.B. 294 (modifying Rev. Proc. 2000-37 to restrict parking of property already owned by the taxpayer).