1031 Improvement Exchange Rules: What You Need to Consider

A 1031 improvement exchange is like a traditional 1031 exchange with improvements added to the exchange. With a traditional 1031 exchange, investors will find a property of at least equal value to exchange. These properties are often turn-key and don’t require big improvements.

In other cases, investors will find a property that can use improvements. Rather than allocating improvement-related funds outside of the exchange, investors will roll them into the exchange. Let’s dig into how this works and some differences with the traditional 1031 exchange.

What Is a 1031 Improvement Exchange?

A 1031 improvement exchange follows all the same deadline rules as a 1031 exchange. With an improvement exchange, a property is acquired and improvements are made. Generally, investors will buy a property of lesser value than the relinquished property and use exchange funds to make improvements.

Because of time constraints, only some of the improvements may be completed by the exchange deadline. If that happens, only the improvements that have been completed count towards the 1031 exchange. 

For example, an investor might go into an exchange with a list of improvements and be able to complete 75% of them by the exchange deadline. This doesn’t mean the other 25% of improvements can’t be completed. They definitely can but won’t be part of the exchange.

The scope of an improvement exchange can vary. It can be a large project or simply dirt work with the build-out of a foundation.

Investors considering an improvement exchange may want to ensure the project is large enough that exchange and financing costs do not overwhelm potential savings.

How Is It Different from a Like-Kind Exchange?

In a like-kind exchange, the investor takes title of the replacement property. In an improvement exchange, the investor does not immediately take title to the replacement property. Instead, the title goes to a qualified intermediary (QI) under a structure called an EAT (exchange accommodating title holder).

The EAT is a special purpose LLC. Instead of the investor buying the property, the QI, via the EAT, will purchase the property. The goal is that the investor can apply all proceeds from the exchange to the improvement project, bringing the value of the replacement property up to that of the relinquished property.

The QI also holds exchange proceeds. When the investor needs funds for their improvement project, they’ll request a draw from the QI. These are the investor’s funds but are held by the QI until the exchange is completed.

Improvement Exchange Rules to Consider

As mentioned above, all the same deadlines apply to an improvement exchange. The investor will have 180 days to complete the improvement project. The full 180 days are available, assuming the investor could find and acquire the property on day one, which is unlikely. Investors must make improvements before the investor takes ownership.

The 180-day rule requires that the work is in service by the end of this timeframe. The investor can’t just buy materials and store them on the property.

By the 45th day, the investor identifies the property and the improvements they want to make to it. However, given the scope of work involved with improvement exchanges, investors will be more motivated to complete property identification and the start of improvements well before the 45th day.

To summarize, when the investor receives title to the property, the QI will transfer the property back to the investor once one of the following conditions are met:

• The project has been completed.
• Exhaustion of exchange proceeds.
• 180-day deadline arrives.

Given the tight deadlines and more moving parts in a 1031 improvement exchange, working with an experienced realtor, QI, and contractor will help ensure the process goes smoothly.