Section 1031 of the U.S. Internal Revenue Code provides real estate investors the opportunity to sell existing real property investments, reinvest the proceeds into the acquisition of qualified, like-kind replacement property, and defer recognition of capital gains realized from the sale to a later disposition, subject to time constraints and other regulations. Such a qualified like-kind exchange, more commonly known as a “1031 Exchange,” can be beneficial to investors holding appreciated investment properties that may otherwise be subject to a large tax liability at the time of sale. But to be able to completely defer tax on disposition, the replacement property must have a total fair market value equal to or greater than that of the relinquished property, and the investor must completely reinvest the sale proceeds into the replacement property, thereby limiting investors’ options. An improvement exchange, however, can provide investors more qualifying options to fully defer tax and the benefit of acquiring the “perfect” replacement property.

1031 Basics

In a typical 1031 Exchange, the Exchanger has 45 days from the date the relinquished property is sold to identify which replacement property the Exchanger will acquire, and has 180 days from the date the relinquished property is sold to actually acquire title to the qualifying replacement property and defer tax on the gain from the sale. But fall outside of the 45-day or 180-day period and the gain from the sale of the relinquished property is fully taxable to the Exchanger.

In addition, to qualify for 1031 Exchange non-recognition treatment, the replacement property also must be qualified and like-kind to the relinquished property. Qualified property is limited to real property. The like-kind requirement is quite general; real property is like-kind to real property. Class or grade of real property is not taken into consideration to be like-kind, meaning that developed real property, such as an apartment complex, is considered like-kind to unimproved real property, such as a vacant lot. Remember that to completely defer tax, the fair market value of the replacement property must be at least equal to the fair market value of the relinquished property, because the total existing investment must be reinvested in the replacement property in order to defer gain attributable to the sale of appreciated property. This is where improvement exchanges can provide substantial benefits.

Improvement Exchange

In an improvement exchange, if planning is done correctly, the Exchanger can direct a third party to construct improvements or repairs to the Exchanger’s exact specifications on replacement property pre-acquisition using tax-free dollars. If the Exchanger sells relinquished property with a high fair market value, and acquires unimproved property with a low fair market value, the Exchanger can use the spread to fund tax-free improvements or repairs to the replacement property. There are three basic methods to accomplish this goal, but under any of the three methods, Exchangers and their advisors should take care to ensure that the benefits and burdens of ownership of the replacement property do not lie with the Exchanger until the replacement property is conveyed to the Exchanger during the 180-day exchange period.

The first method is a forward-deferred exchange, where the Exchanger sells the relinquished property, and a third party exchange accommodator (“Accommodator”) takes title to, holds, and constructs improvements on the replacement property during the 180-day period. The Accommodator must transfer the replacement property to the Exchanger by the end of the 180-day period for the 1031 Exchange to qualify.

The second method is a reverse exchange, under which the Accommodator takes title to the replacement property prior to the Exchanger’s sale of the relinquished property. Because the 180-day period is triggered on the Exchanger’s sale of the relinquished property, the Accommodator is not time-restricted in constructing improvements or repairs to replacement property. The replacement property continues to be held by the Accommodator, even after improvements are complete, while the Exchanger looks for a buyer for the relinquished property. Alternatively, the improved replacement property can be exchanged simultaneously for the relinquished property, which is held by the Accommodator until the Exchanger finds a buyer.

Finally, the Exchanger could arrange for the seller of the replacement property to complete improvements before it is conveyed to the Exchanger, paying for the improvements through a higher purchase price. While this can be beneficial for smaller improvements, because it eliminates the additional cost of using an Accommodator, it can be difficult to find a seller motivated to complete large improvement transactions while also taking on the risk that the sale will fall through, as the seller bears the cost of all improvements made thereon until sold to the Exchanger in the 1031 Exchange.

Improvement exchanges provide investors with flexibility in the market to find replacement investments, as they are not confined to locating a replacement property with a fair market value equal to or greater than the relinquished property in order to fully defer tax. Investors instead have the flexibility to acquire, through the Accommodator, any real property, and use the tax-free spread to make necessary repairs or construct improvements according to exact project specifications.

There are additional requirements and risks to receiving, and this overview does not provide an exhaustive summary of, tax-deferral treatment under an improvement exchange. But with careful planning and an understanding of the regulations, improvement exchanges can provide a great tool for investors looking to invest in the “perfect” property.