Yes, You Can Use 1031 Exchange Funds to Improve Your Replacement Property

Many people are familiar with the “law of fixtures”.  In general, when an item of personal property becomes affixed to a parcel of real estate, that personal property is transformed into real property.  For example, a cabinet is personal property in the home improvement store.  When you bring it home and install it on your kitchen wall it becomes a fixture, and thus real property.

It seems logical, then, that improvements to a replacement property must be like-kind property.  But not so fast…

When it comes to tax-deferred exchanges, timing is everything.  Once the Exchangor takes title to the replacement property, the exchange is completed.  Subsequent improvements will not qualify for tax deferral, even if the funds come from the sale of the relinquished property.

Exchangors often ask if they can use exchange funds to purchase materials that will not be installed in the replacement property until after the closing, or pre-pay for construction services that will be performed at a future date.  The answer in both cases is “no”, even if the payments are disbursed through escrow as part of the replacement property acquisition.

Here is the reasoning.  The exchange begins when the Exchangor transfers real property.  If the Exchangor receives real property plus materials and/or construction services in return, only the real property is like-kind.  To qualify for tax-deferred treatment, the materials have to be real property (i.e. affixed) at the time the Exchangor acquires the replacement property.  Similarly, any construction services performed on the replacement property must be completed prior to closing.  Reg §1.1031(k)-1(e)(4).

So what can be done?  One possible solution is to ask the seller to make the improvements prior to closing, in exchange for a higher selling price.  The purchase contract can be structured so that the Qualified Intermediary pays exchange funds to the seller as additional earnest money deposits or as direct payment for the improvements.

If the seller will not cooperate, the alternative is an improvement exchange.  Similar to a reverse exchange, an improvement exchange requires that a third party take title to the replacement property.  The third party should not be someone who is a related party to the Exchangor under the deferred exchange regulations.  This deal structure gives you a cooperative seller who can make the desired improvements before the end of the exchange period.

In most instances the transaction will be structured in accordance with Rev. Proc. 2000-37.  The Qualified Intermediary, or an affiliate, acquires the replacement property through a single member limited liability company (i.e. Exchange Accommodation Titleholder or “EAT”).  The purchase price may be paid using exchange funds, obtaining a loan to the EAT from a bank or the Exchangor, or some combination thereof.  Unlike in a reverse exchange, the parked property should not be leased to the Exchangor, to avoid constructive receipt issues.

No matter how the transaction is structured, care must be taken to ensure that the replacement property is properly identified.  It is not enough to simply identify the underlying real property.  The improvements should also be identified, especially if they will be extensive enough to change the basic nature or character of the property.  The exchange will qualify even if the improvements are not completed prior to the end of the exchange period (unlike personal property exchanges which require that the replacement property be 100% complete).

An improvement exchange requires careful planning and involves higher transaction costs, but a properly structured improvement exchange will enable an Exchangor to get the property he wants, along with the maximum in tax deferral.

from  First American Exhange Comapny

The Exchange Update

A Newsletter For 1031 Tax-Deferred Exchanges

 

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Improvement Exchanges for Commercial and Residential Property

In the current real estate market there are many opportunities to acquire distressed property at a fraction of the price. Investors can take advantage of this market by selling their relinquished property in a 1031 tax deferred “improvement” exchange and purchasing replacement property that might need construction work or improvements.    

The improvement exchange, also known as a build-to-suit or construction exchange, allows an investor to use the proceeds from the sale of the relinquished property not only to acquire replacement property, but also to make improvements to the property.  For example:

If an investor sells relinquished property with a fair market value of $1 million, debt of $200,000 and equity of $800,000, he must acquire a property equal to at least $1 million and must invest at least $800,000 into that property in order to completely defer his tax in a 1031 exchange.  In an improvement exchange, however, the investor could acquire property worth only $300,000, borrow an additional $200,000 and spend the remaining $500,000 of exchange proceeds plus the $200,000 in loan funds on improvements to the property.  This would use up the remaining cash and increase the fair market value of the replacement property to $1 million, resulting in a fully tax deferred exchange.

Structuring an Improvement Exchange

An improvement exchange is accomplished by having a separate entity called an “exchange accommodation titleholder” or “EAT” temporarily take title to the replacement property while the improvements are being made.  The EAT is necessary because any work done to the property after the investor takes title to it is not considered like kind property and therefore will not increase the value of the property for exchange purposes. First American Exchange creates and owns this entity which holds title to the property for up to 180 days.  During that time frame the investor controls the construction, not First American Exchange.  The costs of construction are paid for either by the investor, a loan, or by using the funds from the sale of the relinquished property.

Benefits and Drawbacks of Doing an Improvement Exchange

The benefits of doing an improvement exchange include the ability to buy property that is lower in value compared to the relinquished property while still having a completely tax-deferred exchange, and to use exchange funds rather than loan proceeds to fund construction. 

The principal drawback of doing an improvement exchange is that the work must be done within the 180 day period in order to have any effect on the exchange.  In addition, improvement exchanges can be more costly due to fees and costs of an additional closing and formation of the EAT. 

Planning for an Improvement Exchange

For those intending to do an improvement exchange, planning ahead is essential. 

  • First, include a provision in the purchase contract that it is assignable in connection with a 1031 exchange.  This is necessary because the EAT, rather than the investor, will be taking title to the replacement property.  
  • Contact First American Exchange and your lender early in the process.  Typically the EAT signs the loan documents and the loan must be completely non-recourse to the EAT.    
  • Get an accurate estimate of the amount of time it will take to complete the construction project.   Although the construction does not have to be complete at the expiration of the 180 day period, the only improvements that will affect the value of the replacement property for exchange purposes are the improvements that are done as of the date that the EAT transfers the replacement property to the exchangor.  
  • Finally, always consult with your tax advisor before doing any exchange, including an improvement exchange. 

By properly structuring an improvement exchange, the investor should have much more flexibility in finding appropriate properties and at the same time completely defer all capital gains tax. 

from First American Exchange Company “The Exchange Update”

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