A 1031 exchange is a tax management tool that allows investors to defer the realization of capital gains taxes when they sell an investment property. The relevant section of the Internal Revenue Code is 1031, which is how the name originated. The IRS oversees these exchanges and stipulates tight deadlines for completion, along with other qualifying characteristics. There are some variations on the original exchange concept, which may broaden the utility for some investors. For example, you can engineer a reverse 1031 exchange if you identify the replacement property before you sell the property you intend to dispose of.
Built-to-suit exchanges can be tricky.
Sometimes, an investor may want to improve a property during the exchange process. One reason to attempt this is if the property you plan to buy has a lower value than the relinquished property. One of the provisions of the exchange rules is that the replacement property (or properties) must be valued at least as high as the relinquished asset. If that condition isn’t met, the exchange will fail, and the capital gains taxes will be assessed on the sale.
To solve the problem, an investor can conduct a build-to-suit exchange, also called an improvement exchange. In this case, the investor may identify their desired replacement property, but it has a lower cost than the relinquished property. If the investor prefers not to pay taxes on the entire proceeds, they must spend the difference on property improvements. The tricky part is that the improvements must be completed within the 180-day deadline for the exchange.
For example, suppose you want to exchange an office building for a residential rental. If the adjusted basis on the office building is $400,000 and the market value/sales price is $800,000, you need to replace that property with a like-kind purchase for at least $800,000. The gain is $400,000, but you must replace the entire sales proceeds, or the remainder (the boot) is taxable.
Now, suppose that the property you identify for the replacement purchase is available for $600,000. To cover the sales price of the relinquished property in the exchange, you will need to spend $200,000 on improvements. You need to ensure that the upgrades are completed within the 180 days that the IRS allows to execute a 1031 exchange.
Also, the improvements need to be detailed during the 45-day identification period, which is a deadline within the 180-day overall time allowed for completing a 1031 exchange. When the investor provides the Qualified Intermediary with the information on the replacement property to be acquired, the description must include the planned improvements.
Using an Exchange Accommodation Titleholder.
Since the improvement exchange is more complex than a typical 1031 exchange process, the Qualified Intermediary who oversees the process will establish an Exchange Accommodation Titleholder (EAT) to hold the proceeds from the relinquished property and pay for the improvements. Once the improvements are complete (again, staying within the 180 days allowed), the QI transfers the property title from the EAT to the investor.
If the planned improvements are incomplete after 180 days, the exchange may still be successful if enough work has been completed to bring the value up to the necessary level.
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.
All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure.
Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Hypothetical examples are for illustrative purposes only.
