Can Repairs Be Included in a 1031 Exchange?

With a 1031 exchange, you can “swap” real estate held for investment or business purposes into other property of equal or greater value (as long as you adhere to the IRS’ in-stone requirements). Meanwhile, the proceeds from your relinquished property or properties can cover costs in addition to that of the replacement property. These might include broker or agent fees, title search costs, and lawyer or CPA fees. 

But can repairs be included as part of that 1031 exchange?  

The first answer is “no.” The purpose of a 1031 exchange is to swap like-kind properties. The Internal Revenue Code doesn’t view “any additional production occurring with respect to the replacement property after the property is received” as a like-kind event.  

So, in terms of a basic 1031 exchange, repairs and improvements can’t be considered part of the deal. These don’t fall under the category of property held for business or investment purposes. Nor are repairs or improvements considered to be of equal or greater value to a relinquished real estate asset. 

There is, however, a version of the like-kind exchange, called an improvement exchange. When planned and accomplished properly, it is possible to pay for a replacement property’s improvement costs by using some proceeds from the sale of your relinquished property. 

Explaining the Improvement Exchange 

The replacement property you’re eyeing could be land on which you want to build. Or it might be a building that requires renovation. Either way, an improvement exchange could help you direct tax-advantaged capital to fix up or build that replacement property. In this situation, the replacement property comes to you at a price that’s equal to the acquisition costs plus the costs of completed upgrades.  

But it’s important to follow these rules to avoid unanticipated tax expenses with an improvement exchange: 

• Any improvements on the replacement property must be completed within 180 days of the closing of your relinquished property.  
• Improvement specifications must be outlined in the comprehensive Exchange Agreement between you and the Qualified Intermediary with whom you’re working before you begin the exchange. 
• You might need to find a qualified Exchange Accommodation Titleholder (EAT), especially if you’re involved with a reverse exchange as part of improving a replacement property. Part of the EAT’s job is to hold, and distribute, funds for the improvement of the replacement property. 
• Upon completion of construction/improvements, the replacement property must be of equal or greater value to the relinquished property. 
• You are the one who must hire the architect and builders and ensure zoning and entitlements for any improvement. 

The Need to Plan Ahead 

If you find a good replacement property that needs upgrading, an improvement exchange could help fund the fix-up of that real asset. But an improvement exchange isn’t something that’s decided  on the spur of the moment. Because this process requires a few extra steps, be sure to check with a qualified professional to help guide you through the procedure.