There’s been plenty written about the 26 U.S. Code § 1031—Exchange of Real Property Held for Productive Use or Investment. When used correctly, the like-kind exchange allows you to swap your relinquished property into a replacement one of greater or equal value. This allows you to defer capital gains taxes on the relinquished property.
There are four ways to complete a 1031 exchange: delayed (the most common), reverse, simultaneous, and improvement. The improvement exchange, also known as the construction exchange, tends to be less common. But it’s useful if you find a replacement property you like, but that needs to be improved before you complete the exchange.
With an improvement exchange, you could use tax-free dollars to build, improve or repair replacement property. But for this to work, you must ensure that the costs involved with that replacement property (i.e., purchase price, closing costs, AND construction costs) are of greater or equal value than your relinquished property.
Here are other issues to consider when dealing with an improvement exchange:
You still need to adhere to the stringent IRS deadlines for a successful 1031 exchange completion. Specifically:
This means that any improvements or construction on that replacement property must be completed within that 180-day period. Failure to complete those changes—or to close by the deadline—could mean the IRS disallows the exchange.
The Qualified Intermediary – QI – is the independent entity that handles the paperwork and monies involved with a successful 1031 exchange. Your QI’s role isn’t all that different when it comes to an improvement exchange. The QI pays for any improvements to the replacement property with proceeds generated from the relinquished property’s sale.
A successful like-kind exchange means that the replacement property must be acquired at a cost equal to or greater than that of the relinquished property. With an improvement exchange, the replacement property is “sold” to you at a price equal to the acquisition costs plus the costs of completed improvements. Again, be sure that those costs are of equal or greater value than that of the relinquished property.
If you want to build or renovate that replacement property, it’s up to you to get it done. Specifically, you need to find the architect, building contractors, and additional personnel necessary to improve the property – all within the 180-day timeline. The QI only pays these professionals. You have to find and hire them.
Certainly, the ability to add capital improvements or build from the ground up using tax-deferred dollars can be a viable investment strategy. But using the improvement exchange requires a lot of work, great attention to detail, and strict adherence to IRS rules and deadlines.
As always, before engaging in any kind of 1031 exchange, check with an experienced professional to answer any questions or concerns you might have.