In recent years, accessory dwelling units (ADUs) have gained popularity. Investors can leverage ADUs to potentially increase rental income and property value, with variations like backyard cottages, basement apartments, and over-the-garage suites providing these advantages.
Given the income-generating nature of these structures, many investors have asked this question: “Can I use a 1031 exchange to build an ADU?” The answer is a little complicated, so Realized 1031 has shared a guide detailing the intricacies of this practice.
Refresher on the Rules of 1031 Exchanges
A 1031 exchange or like-kind swap is a tax-deferred strategy that allows you to exchange “like-kind” properties. Since there is no taxable event, you can defer tax payments for capital gains. When we say “similar,” this means that both replacement and relinquished properties must have been held for investment or business purposes. This is called the qualified use requirement.
Another relevant rule in this discussion is the 180-day rule. This timeline ensures prompt reinvestment and prevents the taxpayer from taking constructive receipt of the proceeds, which would otherwise trigger a taxable event.
Can You Build an ADU With 1031 Exchange Funds?
With the provisions we shared above, you cannot use 1031 exchange funds to build or improve a property you already own. The traditional like-kind exchange will require you to swap one asset for another. As such, the funds must be used to acquire a replacement property.
However, it is possible to build an ADU on the replacement property, all thanks to the built-to-suit exchange.
The Built-to-Suit Exchange
Also called the improvement exchange, the built-to-suit exchange is a variation of the 1031 exchange. This process allows you to use the home sale funds to make capital improvements on the replacement property. These enhancements can include ADUs.
Built-to-suit exchanges are more complex than traditional like-kind swaps because you cannot own the title to both the replacement and relinquished property at the same time. This restriction makes it harder to make improvements on the replacement property. Therefore, you need to take additional steps to ensure that you remain compliant with IRS rules.
- You sell the relinquished property.
- Your qualified intermediary holds the proceeds.
- An exchange accommodation titleholder (EAT) temporarily holds the title to the replacement property on your behalf.
- During the 180-day exchange period, the EAT uses the funds to build or improve the property, such as adding an ADU. The taxpayer cannot take possession of the property or exert control over the exchange funds or construction during this period.
- Once the improvements are complete (or the 180 days expire), the improved property is transferred to you.
One more rule you have to follow is the equal-or-greater-value requirement. As such, the combined values of the replacement property and the ADU must be equal to or greater than the value of the relinquished property. Otherwise, you incur a cash boot, which is taxable.
Wrapping Up: 1031 Exchange ADU Basics
Building an ADU using 1031 exchange funds is possible, but it requires adherence to specific IRS rules and structured processes. Plus, you can only make these improvements on the replacement property if you’re planning to take this path to potentially increase rental income and property value. Working with a qualified intermediary and consulting a tax advisor or real estate attorney is essential to help ensure compliance and support a successful exchange outcome.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
Sources:
https://www.thetaxadviser.com/issues/2016/oct/front-end-straw-man-and-build-to-suit-exchange.html
