Can an Investor improve a Replacement Property using proceeds from a §1031 Exchange without paying capital gain on it? The simple answer is yes. Proceeds from a §1031 Exchange may be used to make improvements to a Replacement Property. A Construction Exchange is a valuable tool, allowing Investors to both save taxes and modify their Replacement Property to better suit their investment objectives.
A Construction Exchange (also known as an “Improvement Exchange”) allows the property owner to use the proceeds from the sale of the Relinquished Property to buy a Replacement Property and either build a new structure on it or renovate an existing building. While the structure is more complex than a Forward Exchange, it can be worthwhile in certain situations. Here are some of the basics of how it works.
Similar to a Reverse Exchange, title to the Replacement Property is “parked” with an Exchange Accommodation Titleholder (EAT), which is usually a Limited Liability Company (LLC) that is solely owned by the Qualified Intermediary facilitating the §1031 Exchange.
At the time of the acquisition, the EAT can enter into a Construction Agreement with the Investor. The Investor can then make improvements to the property during the balance of time of the Exchange period, using a portion of the sales proceeds from the Relinquished Property to pay for the construction. Once the work is completed or the Exchange period is about to expire, the EAT will transfer the property to the Investor at its improved value.
For example, if an Investor sells a property for $1 million, he will need to acquire a Replacement Property worth at least $1 million to defer fully his capital gain taxes. Suppose he found an ideal property priced at only $700,000, but it needed renovations such as replacing the roof and windows and repaving the parking lot. In a properly structured Construction or Improvement Exchange, the EAT would acquire title from the Seller of the property, using a portion of the sales proceeds to pay the purchase price. Then, during the balance of the Exchange period, the EAT would use the remaining sales proceeds to make the needed renovations. If the capital improvements cost at least $300,000, the Investor would be able to defer fully the taxes on the capital gain.
Unfortunately, the Exchange period is a maximum of 180 days, so there is not much time to complete the necessary work. Therefore, an Improvement Exchange is usually easier to accomplish with the rehabilitation of an existing structure than construction of a new structure on vacant land. Additionally, the Exchange funds may not be used to make improvements to a property that was previously owned by the Investor. Nor is it sufficient to simply purchase supplies during the Exchange period. The work must be 100% completed, and progress of the construction should be documented. It is also critical that both the Replacement Property and the planned improvements be “identified” during the 45-day identification period. Finally, the construction or improvements made must be considered capital improvements as opposed to routine maintenance and repairs.
Clearly, a Construction Exchange is a complex tax-deferred strategy. It is important to get legal, financial and tax advice from qualified professionals before entering into any Construction Exchange. If you need guidance on your particular situation, call the experts at Madison 1031 – a Qualified Intermediary (QI) — to discuss whether a §1031 Exchange makes sense for your real property.
