Can You Use a 1031 Exchange to Build an Investment Property?

1031 exchanges are tools that can enable real estate investors to defer the payment of capital gains taxes when they sell an investment property and reinvest the proceeds. However, if you complete a sale and purchase outside the auspices of a 1031 exchange, you will owe capital gains taxes on the difference between the adjusted basis and the sale price.

For example, suppose you have owned a piece of land for five years. You paid $250,000 for the property and associated acquisition costs and spent $100,000 on improvements, making your adjusted basis $350,000. If you sell the property for $600,000, you will owe capital gains taxes on the $250,000 difference. If you are in the highest bracket, that could be $50,000.

Suppose instead that you conduct a 1031 exchange and reinvest the proceeds from the sale in a new property, adhering to the procedures and timelines the IRS created for the transaction. As a result, you can reinvest the entire $600,000 rather than $550,000. Some of the essential requirements are:

1. You must use a Qualified Intermediary to manage the process. The QI creates an account to hold and manage the proceeds between the initial sale and the final acquisition.
2. You must identify potential replacement properties within 45 days of the sale and complete the purchases (or purchases) within 180 days from the start.
3. You must match the value and debt levels.

It’s a complex transaction, and the timelines are tight, but the tax deferral can allow for greater leverage. In addition, you can continue to employ the tool for subsequent investments, culminating in a transfer when you die, which the heir will receive at the stepped-up value, ultimately eliminating the deferred taxes.

What if I want to build on the property?

There are ways to use a 1031 exchange to build on the replacement property. First, if the replacement property, before any improvements is equal in value to the relinquished asset, you can complete the exchange and build as desired. But, if the designated replacement property needs improvements to meet the value of the relinquished asset, you must complete the work within the 180 days allowed for the exchange. Furthermore, the investor must outline the planned improvements within the initial 45-day timeframe that is offered to identify replacement property.

Can I transact a 1031 exchange into new construction?

Remember that one of the key provisions of the 1031 exchange is that the replacement property must be equal to or greater than the value of the relinquished asset. Suppose you are selling a retail property and want to build a multifamily housing structure on vacant land. You can, but it’s tricky. Again, if the new asset's value is already equal to the original property, there is no problem. If the new acquisition is of lower value until the construction is completed, it must be done by the end of the 180-day period. In the interim, the title must be held by an intermediary.

With any 1031 exchange, it’s crucial for the investor to follow the rules, particularly the timelines, and to use a skilled intermediary.