Real estate investors hoping to complete a 1031 exchange often run into the problem of satisfying the “like-kind” requirement of finding a property of equal or greater value, especially in hot real estate markets with fewer available properties and a larger pool of potential buyers.
One workaround to meeting the like-kind requirement is to make capital improvements on a replacement property using equity gained from the sale of the relinquished asset. This process is known as a 1031 improvement exchange, or a build-to-suit exchange. There are several potential benefits to this approach, as well as some IRS requirements that need to be met in order to ensure your exchange isn’t disqualified.
What Are the Benefits of Completing a 1031 Improvement Exchange?
A 1031 improvement exchange can prove beneficial to real estate investors in quite a few different scenarios.
Two key tenets of successfully completing a 1031 exchange are finding a like-kind replacement property within 45 days of selling your original asset and wrapping up the entire exchange process within 180 days. Finding a suitable asset can prove especially challenging -- that’s one reason why some investors opt to purchase shares of a Delaware Statutory Trust (DST) to complete their exchanges since they can buy the exact amount needed to satisfy the like-kind stipulation.
Alternatively, however, you can refurbish a property -- or even build a new structure from the ground up -- using capital gained from the sale of your relinquished asset. This strategy allows you to invest additional tax-advantaged capital into a replacement property, which can increase its market value and satisfy the like-kind requirement. It also can result in a more desirable and better-positioned asset if significant capital improvements are completed to modernize and upgrade an aging property.
If you choose this type of exchange, you’ll have to pay close attention to deadlines. You don’t necessarily need to have all the work completed on the replacement property within the 180-day window. Only improvements completed within the 180-day timeframe are considered tax-deferred, and if improvements are ongoing the property might not increase enough in value to meet the like-kind exchange provision. In order to determine the final value of the replacement asset, you can add its purchase price to the amount of capital invested for improvements.
The Bottom Line
Investors who choose this type of exchange are responsible for all aspects of the construction and improvement process, including negotiating construction and design contracts and obtaining any necessary permits and inspections. These measures can be complicated to novice investors with no prior renovation experience or network of trusted construction professionals.
Time is of the essence if you are considering a 1031 improvement exchange. The only way you can fully defer all your investment capital is to have all renovation work completed in 180 days, which is just shy of six months. While that may seem like a lot of time, any lengthy delays or unexpected construction issues -- which commonly crop up when renovating older buildings -- can wreak havoc with the project schedule. Failure to meet the 180-day requirement could result in a taxable event and leave you with a large capital gains liability.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.