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1031 Exchanges Involving Construction and Property Improvements for Dummies

Martin S. Edwards, JD, CES®
10/23/23
Take the title with a grain of salt, as it is meant in jest. This article is merely a great overview and high-level introduction into unfamiliar territory for many - Improvement Exchanges. Learn more about how a 1031 Exchange can be utilized in transactions where construction or improvements are desired on the Replacement Property.
1031 Exchanges Involving Construction and Improvements for Dummies

There are times when an Exchanger sells the Relinquished (old) Property for a higher value than the purchase price of the property to be acquired, referred to as the Replacement (new) Property. If nothing further is done, the left-over funds would be considered “boot” and fully taxable. An attractive alternative to a taxable event is to utilize the excess funds to make improvements or build from the ground up on the new property, known as an Improvement, Construction, or Build-to-Suit Exchange .

Circumstances Requiring Build-to-Suit and Improvement Exchanges

These fact patterns arise in two different ways. Perhaps the most frequently seen fact pattern is where the client has sold the old property, and identified a potential new property that would result in leftover funds, and the Exchange r wants to use those funds towards improving the new property from ground up or improvements to the existing property. For the purpose of this blog, let’s refer to both the ground up and improvements simply as improvements. The Improvement Exchange can include not only the improvements, but the value of the land purchase as well.

The other variation takes place where the taxpayer actually wishes to acquire the new property and begin the improvements before selling the old property. This scenario may be used if there are weather factors requiring improvements be completed as soon as possible or for a business to relocate in which the new property is needed as soon as the old one is sold. This version is “reverse” in nature since the new property will be acquired before the old one sells. While the order of events in these two scenarios differ, both are handled in the same way as a Reverse Exchange, but a standard Reverse Exchange doesn’t include building or improvements.

Meeting the “Like-Kind” Requirement in Improvement Exchanges

Most people know that IRS Section 1031 involves trading “like-kind” real estate. However, once an Exchange r acquires the new property, any improvements made after the acquisition constitute payment for labor and materials, and those payments would not constitute receipt of “like-kind” real estate.

IRS Rev. Proc. 2000-37

When the IRS came out with rules for this situation in the year 2000, those rules contained a path on how to structure such a transaction so that improvements could be completed with exchange funds prior to acquiring the new property. If structured the way the IRS recommends, the Exchange r will meet the “safe harbor” provided for under the rules. The benefit of being in the safe harbor is that the IRS is approving the structure in advance as to form. Think about the fact that insurance on your home protects you from loss, if applicable. The safe harbor is essentially insurance that protects you against a possible claim, or audit, that your Improvement Exchange fails to meet IRS requirements.

Process of an Improvement Exchange

The process is rather simple and many steps mirror those of a Reverse Exchange . The taxpayer engages with an exchange company, who will, for a fee, agree to acquire the new property at closing and improve it per the Exchange r's direction. Once the improvements are done, and subject to meeting the 1031 timelines, the taxpayer receives title from the exchange company. That way, the value of the improvements is already “baked into” the value of the property upon Exchange r’s receipt and the Exchange r will get total tax deferral.

Roles in an Improvement Exchange

When doing a conventional exchange of old property for new property, pursuant to other IRS rules, the exchange company acts as a Qualified Intermediary (QI). However, when an exchange company is acting in connection with an Improvement Exchange, it is facilitated by an entity referred to as an Accommodator per the 2000 rules, technically known as a Qualified Exchange Accommodation Titleholder or (EAT). The EAT takes legal title to the new property through a new LLC to separate and insulate it from other Improvement and Reverse Exchanges that it is facilitating for other Exchangers at any given time.

Be advised that in these transactions, doing a reverse exchange does not mean that the forward exchange need not take place. The EAT holds, or parks, title to the new property and allows taxpayers to get the intended improvements in place. However, the QI facilitates the actual 1031 Exchange of the old property for the new property. A reverse exchange is not a substitute for the conventional 1031 exchange.

At times, the exchange company can service both portions of an Improvement Exchange , the forward 1031 exchange and the "parking” improvement portion as the QI and the EAT. Although one exchange company can “wear both hats,” many exchange companies across the country choose only to service forward exchanges. In that case, the QI might refer the client to an EAT that works in tandem with the QI in connection with their respective services. Accruit is one that offers both QI and EAT services.

Increased costs and complexities are a couple reasons that some QIs choose not to offer services for Reverse exchanges. Also, since the EAT needs to take title to the new property, that could result in greater exposure to potential liability, for example, if a person is injured on the property or if there is an environmental issue associated with the property. Some exchange companies prefer to avoid any such exposure.

Costs Associated with Improvement Exchange

On a relative scale, an Improvement Exchange is more costly than the standard forward 1031 exchange. As a practical matter, Exchange rs generally have little issue with the higher fee since the service allows them to avoid substantial tax that would otherwise be owed without this technique. The fee to the EAT can be paid out of exchange funds and the fee and other soft costs incurred count making it closer to reach the amount of funds needed to be spent. In fact, the EAT can even reimburse the Exchange r for past and present expenses that the Exchange r has advanced. To make this happen the Exchange r must keep records of the invoice or bill and be able to present evidence that the expense has been paid.

 

The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified  Intermediary , and as such does not offer or sell investments or provide investment, legal, or tax advice.