Can a 1031 Exchange Include Renovations?

The 1031 exchange can be useful as a real estate tax-advantage strategy. If you exchange your relinquished property for a replacement property of equal or greater value within the IRS deadlines, you could defer capital gains and depreciation recapture taxes to a future date. 

But what if your designated replacement property requires upgrades? There’s a like-kind exchange for that. It’s known as the 1031 improvement exchange or the build-to-suit exchange.

How it Works

An improvement exchange means you can take some of the proceeds from selling your relinquished property and direct them to upgrade the targeted replacement property. For example, you paid $500,000 several years ago to buy a property for investment purposes. That property is now worth $1 million.

You want to sell the property but are reluctant to pay the $500,000 capital gain taxes. You decide to seek a replacement property, but the available ones are well above the $1 million you can generate from the relinquished property. Fortune smiles on you, bringing you a possible replacement property for $750,000. 

But there might be a couple of problems: 

• The replacement property doesn’t fit into the “equal or greater value” requirements mandated by the IRS for a successful exchange
• The replacement property needs improvements, specifically, a new roof, HVAC system, and landscaping

This is where the 1031 improvement exchange can help. When you sell your relinquished property for $1 million, you could use $750,000 to acquire the replacement property. Then, you could use the remaining $250,000 to make the necessary improvements. 

Why it Could Be Advantageous

One main benefit of the build-to-suit exchange is similar to the standard 1031 exchange – possible tax deferral. Other benefits can include:

• Improvement of the replacement property’s market value
• Diversification as you exchange a current property for one that could offer more income potential
• Flexibility, as you’re not limited to an existing property but could use your funds to make improvements to a replacement property that has a lower value
• A customized replacement property, one that could be tailored to fit your particular business or investment needs

Beware of the Downsides 

While the 1031 improvement exchange can be an essential part of your investment strategy, there are certain issues to watch. 

The Deadlines

A successful like-kind exchange means adherence to strict deadlines set by the IRS. This is true with the 1031 improvement exchange. Specifically:

• 45 days from the sale of your relinquished property to identify a replacement property
• 180 days from the sale of your relinquished property to buying that replacement property

The additional wrinkle in a build-to-suit exchange is that you must identify replacement property improvements within the 45-day exchange period. 

The Paperwork

Remember that 180-day deadline? With a 1031 improvement exchange, you must also begin renovations within that period. This includes all activities connected with the hammer-and-nail activities, like municipal permitting and zoning approvals and design and construction contract negotiations. Furthermore, financing needs to be nailed down for the project.

Tax Deferral Issues

To help maximize tax deferral, the value of the improved replacement property should be equal to or greater than that of your relinquished property. This doesn’t mean you must complete all improvements by the time you take title to the property on day 180. However, only the completed portion of the renovations are eligible for the exchange.

Anyone who has worked on renovations and construction understands that lengthy delays can happen due to weather, materials shortages, or other factors. Because of this, the chances are pretty good that the replacement property renovation might not be complete by the time you close the replacement property. This could call into question whether the completed portions fall into the “equal or greater value” category of a replacement property.

Weighing the Benefits and Costs

A 1031 improvement exchange can be helpful as a tax-advantaged strategy. It can also help you find a real estate asset with more potential. But the process is complex. It requires strict adherence to IRS deadlines, plus other activities to ensure a qualified replacement property. Because of the many moving parts associated with a build-to-suit exchange, work with a qualified professional to ensure the process goes off without a hitch.