§1031 Improvement Exchange

A 1031 improvement exchange (also known as a build-to-suit exchange or construction exchange) under §1031 of the Internal Revenue Code (IRC) allows a taxpayer to use proceeds from the sale of a relinquished property to improve or build on a replacement property while still deferring capital gains taxes. This type of exchange provides flexibility for investors who want to acquire a property that does not currently meet their investment needs or standards but can be developed or improved to do so.

Are you ready to maximize earnings on your real estate investment or learn more if a 1031 improvement exchange is right for you? Contact our 1031 exchange intermediary team at 314-822-8100 for a free consultation and to start developing your strategy.

How an Improvement Exchange Works:

In a standard §1031 exchange, the taxpayer simply sells one property and buys another qualifying "like-kind" property. However, in an improvement exchange, the taxpayer uses the funds from the sale of their relinquished property to either:

• Purchase a replacement property that requires improvements (e.g., renovations, repairs, or upgrades), or
• Construct a new property from the ground up.

To ensure the transaction qualifies for tax deferral under Section 1031, the exchange must follow certain rules and timelines similar to a tax deferred exchange, with a few additional considerations specific to the improvements.

Key Elements of a1031 Improvement Exchange:

1. Qualified Intermediary (QI) and Exchange Accommodation Titleholder (EAT): Like other §1031 exchanges, a Qualified Intermediary (QI) must facilitate the transaction to hold the sale proceeds from the relinquished property. However, in a 1031 improvement exchange, an additional party known as the Exchange Accommodation Titleholder (EAT) is involved.
   • The EAT will be formed as a limited liability company.
   • The EAT takes title to the replacement property and holds title under the terms of an exchange agreement during the period within which the improvements are being constructed/added to the replacement property.
   • Once improvements are completed:
     1. title to the replacement property can be conveyed to the taxpayer to complete the exchange; or
     2. the membership interests in the EAT are transferred to the taxpayer to complete the exchange.
2. Identification of Replacement Property (45-Day Rule): Similar to a deferred exchange, the taxpayer has 45 days from the sale of the relinquished property to identify the replacement property. In the case of an improvement exchange, the taxpayer identifies both the real property and the specific improvements that will be made to it.
3. Completion Period (180-Day Rule): Under the safe harbor regulations the taxpayer has 180 days from the sale of the relinquished property to complete the acquisition of the replacement property and any improvements.
4. Value Requirement: The total value of the replacement property, including the improvements, must be at least equal to the value of the relinquished property in order to defer all capital gains taxes. If the improvements are not completed within the 180-day window, only the value of the property as it stands at the time of transfer will be used for tax purposes. Any leftover proceeds may be treated as boot, which can be taxable.
5. Property Must Be Like-Kind: As with any 1031 exchange, the replacement property and improvements must be "like-kind" to the relinquished property, meaning they must be: a) considered real estate once constructed; and b) used for investment or business purposes.

Example of a 1031 Improvement Exchange:

• Day 1: The taxpayer sells a commercial property for $800,000. The sale proceeds are held by the Qualified Intermediary.
• Day 45: The taxpayer identifies a vacant lot as the replacement property and provides a plan for constructing a commercial building on it. The vacant lot costs $300,000, and the planned improvements are estimated to cost $500,000.
• Day 60: The Exchange Accommodation Titleholder (EAT) purchases the vacant lot with the funds from the relinquished property sale and starts construction of the commercial building.
• Day 180: At the end of the 180-day period, $500,000 worth of improvements are completed on the lot, making the total value of the property $800,000 (matching the value of the relinquished property). The EAT transfers the title of the improved property to the taxpayer, completing the exchange.

Advantages of an Improvement Exchange:

A 1031 improvement exchange offers a number of benefits to real estate investors:

1. Customization: The taxpayer can acquire a property that doesn’t meet their needs at the outset and use the exchange funds to make necessary improvements.
2. Tax Deferral: By using Section 1031, the taxpayer defers capital gains taxes on the sale of the relinquished property, freeing up more capital for improvements.
3. Maximizing Value: The taxpayer can use all the sale proceeds (or more) to increase the value of the replacement property, reducing or eliminating the risk of receiving taxable boot.

Challenges and Considerations:

There are some important considerations and requirements that must be met in order for a 1031 improvement exchange to be complete. Because of this, working with experienced professionals is crucial. Some considerations include:

1. Time Constraints: Completing significant improvements within the 180-day timeframe can be challenging. If the improvements are not finished, only the value of the property as it stands at the end of the exchange period will be counted for tax deferral purposes.
2. Complex Structure: The involvement of an Exchange Accommodation Titleholder (EAT) and the complexity of construction can make improvement exchanges more complicated than standard exchanges.
3. Higher Costs: Improvement exchanges typically involve higher transactional and legal costs due to the added complexity and the need for an EAT to hold title during the improvement phase.

Overall, an improvement exchange provides a powerful tool for real estate investors looking to upgrade or develop properties while deferring taxes on their gains under Section 1031.

Contact 1031 Exchange Intermediaries to Get Started

A 1031 improvement exchange offers property owners the unique opportunity to defer capital gains taxes while upgrading their investment properties. By allowing for the reinvestment of proceeds into improved real estate, investors can enhance their portfolios and maximize returns without the immediate tax burden. However, navigating this process can be complex, making it essential to work with experienced professionals who understand the intricacies of 1031 exchanges.

At 1031 Exchange Intermediaries, we specialize in guiding clients through every step of the exchange process. Our expertise ensures that you can take full advantage of the 1031 improvement exchange benefits while minimizing risks. Contact us today to start your journey toward successful reinvestment and property enhancement!