In a 1031 exchange, capital gains taxes can sometimes be deferred when selling one investment property and using the funds from the sale to purchase a like-kind replacement property.
In some cases, an investor might identify a replacement property that is in need of improvements. While specific improvements might not render a property ineligible for a 1031 exchange, certain requirements can impact whether or not an exchange might qualify for capital gains tax deferment.
1031 Improvement Exchange
A 1031 exchange where a replacement property will undergo improvements is called a 1031 improvement exchange.
The replacement property should be equal or greater value than that of the relinquished property. If the property is not of equal or greater value, improvements might be made to qualify the property as a like-kind property in the exchange. However, the improvements must be identified within the 45-day identification period and completed before the 180-day exchange period discussed below.
45-Day Identification Period
In a 1031 exchange a replacement property needs to be named by the investor within 45-days of selling the relinquished property. For an improvement exchange, both the property and a list of any improvements that will be made needs to be identified within this timeframe.
In addition to a 45-day identification period, there is an 180-day exchange period in which the exchange needs to be completed, including improvements. Only work completed within the 180-days is eligible for potential tax-deferment.
However, if an investor takes title to the replacement property before improvements are made to bring the property to equal or higher value than the relinquished property, it doesn’t qualify for a 1031 exchange. Instead, there is an Exchange Accommodator Titleholder (EAT).
The exchange value of a property is the value when the taxpayer closes on the replacement property, if the improvements haven’t been made it might not be considered a like-kind property.
The Bottom Line
Equity gained from the sale of a relinquished property can sometimes be used to make improvements to the replacement property in a 1031 exchange. To recap, there are a few things to keep in mind.
- Improvements must be completed on the replacement property within the 180-day exchange period.
- The investor cannot take title until the improvements are made in order to have the potential to qualify as a 1031-exchange.
- Exchange value is the value of the property when you close on the replacement property, so if the improvements haven’t been made it might not be considered a like-kind property.