This exercise is not as it stands a very good example, because the active sentence is ambiguous; but the point behind it is important.
The people who composed this exercise have some reason to think of the preposition phrase as a modifier of the object. From what you have provided we have no way of knowing why they think that, but it may be apparent in the larger context.
The first example is presumably preferred because it keeps the preposition phrase next to our school in its original position after institute, where it may be understood as a predicate complement locating institute. In the second example the preposition phrase is separated from institute and now tells where the institute is being built: it modifies verb.
In this particular case, of course, it makes no significant difference: the institute ends up in the same place either way! But consider this sentence:
They are tearing down the school for the deaf.
If you passivize this following the first example, you have:
The school for the deaf is being torn down by them.
That's presumably what the original active sentence means. But if you passivize it following the second example you get something quite different:
The school is being torn down by them for the deaf.
That says that tearing the school down is intended to benefit the deaf, which seems very unlikely.
The lesson to be taken from this is that when you passivize and move pieces into new roles and new positions, you must be careful to keep all the pieces in their proper places.