The least known but fastest growing types of exchange is the improvement 1031 exchange. Also known as a build-to-suit or construction exchange, it allows you to use part of the value in your old property to improve a new property. Say you sell a property worth $400,000. You can then purchase a $250,000 property and add $150,000 in improvements tax free. Investors love the improvement 1031 exchange because it offers more flexibility than typical exchanges. You can buy replacement properties that are the same value or higher. Not just that, you can also purchase lower priced properties or even vacant land!
In this article, we’ll walk through the rules, pros and cons, and how to plan for an improvement 1031 exchange.
Pros of Improvement 1031 Exchange
The largest benefit of an improvement 1031 exchange is the ability to purchase a replacement property of any value. This increases the number of properties you can purchase and helps you find the “perfect” replacement property. It also allows you to exchange between types of commercial real estate easier. For example, if you sell a $500,000 duplex, you now can trade into vacant land or an old warehouse. Under a traditional exchange, this would not be possible.
Another benefit is the ability to use exchange funds for construction, rather than from a loan. Last, you are also able to extend the 1031 timelines. Construction can last longer than 180 days if the value is equalized before the deadline.
There are a few cons as well. The largest is that 180 days is usually not enough time to do a bottoms-up construction or a large project. Next, improvement 1031 exchanges are more expensive than typical exchanges since the Exchange Accommodation Titleholder (EAT) takes title. There could be a double charge for escrow, transfers, and closing costs since the EAT has to deed the property back to you. Overall, the is more risk in an improvement exchange. Qualified intermediaries usually charge more to offset this increase in risk.
Improvement 1031 Exchange Rules
An improvement 1031 exchange has similar timelines to a traditional exchange. The twist under an improvement exchange is that you must complete construction in 180 days to maintain tax-free status. Additionally, construction plans are the “identification” and still must be filed within 45 days. For example, say you sell a property and have a replacement lined up. Submitting construction blueprints and permits is sufficient for the 45-day identification. After that, improvements must be completed within 180-days and similar to the construction plans.
Under any 1031 exchange, you cannot hold title to both properties at the same time. To work within this limitation, your new property must be held by a third party during construction. This third party is called an Exchange Accommodation Titleholder (EAT). Your qualified intermediary can help set this up. You still control the improvements, but the EAT pays for contractor invoices from funds they hold for you.
An improvement 1031 exchange can either be a delayed exchange (more common) or a reverse exchange (less common). We’ll walk through both to see which is best for your situation.
Delayed Improvement Exchange
In a delayed 1031 improvement exchange, you sell your property first and the proceeds go to your qualified intermediary. After this, you must identify the replacement property and submit a plan for the improvements within 45 days. The EAT then acquires the new property using the exchange money. All construction costs are paid from the remaining amount.
You take title to the new property once the 180 days expire or the cost of the replacement plus construction equals the original amount, whatever is sooner. Note that you do not need a certificate of occupancy, or even complete the improvement. For example, say you sell a $500,000 property then buy a $400,000 property with plans to improve it by $300,000 in total. Once you have made $100,000 in improvements, you can take title to the replacement property and continue construction. The first $100,000 of improvements are tax-free under this scenario.
Something to keep in mind is that your qualified intermediary is holding a large sum of money on your behalf, accruing interest. Delayed improvement exchanges are cheaper than a reverse improvement. However, you are still forgoing interest income while the proceeds from your sale sit in the bank. Considering improvements will take closer to the full 180 days, it’s important to consider how much of the interest income you will get back. For the proceeds from a $500,000 property sale, 6 months in a bank at 2% is $5,000 in potential interest income.
Reverse Improvement Exchange
In a reverse improvement exchange, your qualified intermediary acquires the replacement property first. While this can be tricky to finance and requires large upfront costs, it can provide greater flexibility to find the perfect replacement property. Instead of scrambling to find a replacement after the sale, you can spend the bulk of time searching, knowing that your old property can be sold slightly below market much quicker.
Similar to a delayed improvement exchange, the EAT pays for construction costs. The difference is that since your old property has not sold yet, you or a lender must lend the EAT money for construction. Many lenders will not feel comfortable with this type of arrangement, and you may need a hard-money lender.
During the 180-day improvement period you must sell your old property, and construction can be funded using these proceeds. Similar to a delayed improvement exchange, you take title to the replacement after 180-days or the property value is equalized, whatever comes sooner.
How to Plan for your Improvement 1031 Exchange
Doing an improvement exchange without planning ahead is nearly impossible, and without a qualified intermediary you’re toast. Make sure you’re covered on these before you kick off an improvement exchange.
- Get in touch with a qualified intermediary before you sell your existing property
- Identify the replacement property and ensure it is like-kind. 1031 exchanges are only for rental, investment, or business properties
- If doing a reverse improvement exchange, identify funding from a mortgage lender or private hard-money lender
- Estimate if the construction can be equalized within a 180-day period. Engineering and architecture fees, permit fees, lawyer and CPA fees can all be reimbursed tax-free
- Once construction plans are made, ensure they are submitted to your qualified intermediary before day 45. You also need to submit a detailed description of the property and location
- Once construction is completed and the cost of replacement property + construction, ensure that the improvement is similar to what was outlined during the 45-day identification period
Can you do a 1031 improvement exchange on property already owned?
The short answer is yes, the longer answer is it’s complicated. This may be worthy of its own post, but it is made possible through complex, long-term leases. By structuring an exchange this way, improvements made to a lessee’s property are not technically their own. Contact a qualified intermediary who has experience with improvement exchanges on already owned property.
During the 45-day period, how do you submit your improvement plans?
Since you do not own the property during the improvement period, you must disclose this to the IRS. Typically you need to identify both the location and and construction blueprints, along with estimated construction costs. E.g. Buying the single family home at 1234 Broadway Austin, TX 78704 and converting the 2nd and 3rd stories to its own apartment, and building a kitchen on the 2nd level. You would then usually need to submit architecture diagrams with the improvement plans.
How do I negotiate the construction contract when I don’t own the property?
The contract will be in the name of the LLC that your qualified intermediary sets up to take title to your property. You will add a clause that enables you to assume the contract after the exchange is equalized and you take title from the EAT.
How do I work with a construction lender during the process?
Construction lenders are generally used to working on improvement exchanges. During construction, you and the general contractor will work on a “draw request.” This shows the current state of construction and running costs. The draw request is approved by you first, then by your qualified intermediary before it is returned to your lender. After the lender receives it, they will pay out the funds needed to your general contractor.