Internal Revenue Code Section 1031 outlines specific regulations to help you defer tax payments on the sale of real estate for investment or business purposes. Different types of exchanges also provide flexibility, depending on your circumstances. One of these is the improvement, build-to-suit, or construction 1031 exchange. Through this process, you can still swap a relinquished property for a replacement property as long as you follow the IRS rules. Additionally, renovations are involved, which can impact costs and deadlines.
Defining the Improvement Exchange
In a perfect world, you would find the ideal replacement property. But this might not always be the case. You might see a potential replacement property with “good bones,” but it needs work to get it up and running to your standards.
This is where the improvement 1031 exchange can help. Through the exchange process, you could sell your relinquished property and find a replacement property of lower value–as long as:
- The improvements you make increase the replacement property’s value to an amount that is equal to or greater than the purchase price and completed improvements of the relinquished property to fully defer taxes. Any shortfall (boot) may be taxable.
- The improvements must be completed within 180 days of the relinquished property sale. Improvements that aren’t completed by the deadline are subject to tax liabilities.
- You work with an exchange accommodation titleholder (EAT), who holds the title to the replacement property until you own it outright. This is because you cannot own the relinquished and replacement properties simultaneously.
You can increase the value of the replacement property under an improvement exchange through actions including:
- Structural improvements
- Room additions and building expansion
- Interior renovations
- Exterior renovations like landscaping and parking lots
- Utility system upgrades
- Energy upgrades such as solar panel systems
- ADA compliance upgrades
How It Works
An improvement exchange is the same as a standard exchange in that:
- A Qualified Intermediary (QI) is necessary to control the proceeds and ensure compliance with IRS rules
- You must adhere to the 45-day identification and 180-day closing deadlines
However, an improvement exchange also must have the following:
- An EAT to acquire and hold the replacement property until you close on it
- Completion of improvements or upgrades within 180 days of your relinquished property’s sale
- Title transfer from the EAT as part of the closing process
Is a Construction Exchange the Best Option for You?
Embarking on an improvement exchange can be complex as more parties are involved. If contractors are delayed or materials aren’t received in a timely fashion, you risk missing the 180-day deadline, triggering a taxable event.
However, the following could be justification for an improvement exchange:
- Customization: An improvement exchange can help you customize the replacement property based on your operational or investment requirements.
- Wider property pool: If you can’t find a replacement property of equal or greater value to your relinquished property, targeting a property with appreciation potential might be the right move.
In closing, an improvement exchange can be viable, depending on your investment goals and what you want to achieve from a replacement property. Conducting a successful exchange can help you increase an asset’s value while potentially deferring payment on taxes and depreciation capture.
However, certain steps are necessary for a successful improvement exchange. Because of this, be sure to put together a team of knowledgeable professionals who know the process well and can guide you.
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.
