Improvement 1031 Exchange: The Ultimate Guide to Rules and Costs

Last updated on June 24th, 2021 at 12:37 pm

Rules and requirements | Improvement 1031 exchange examples | Pros and cons | Improvement 1031 exchange planning checklist | FAQs

An improvement 1031 exchange is when you sell an investment property and use part or all of the proceeds to make improvements to your replacement property. 

In a conventional deferred 1031 exchange you sell your initial property, known as the relinquished property. Then, through a qualified intermediary (QI), you flip those funds into a replacement property while deferring capital gains.

But let’s say you’re selling a $1 million property, and you’ve found a $750,000 property that needs $250,000 in improvements. This is where an improvement 1031 exchange comes into play.

You can sell your initial property for $1 million. Then, through your qualified intermediary, you purchase the $750,000 property and perform the $250,000 in construction with your sale proceeds — while deferring capital gains.

» LEARN MORE: 1031 exchange terms and definitions

Use an improvement 1031 exchange to build a new property 

Let’s say you’re selling the same $1 million investment property, but you can’t find any replacement properties you want. Using an improvement 1031 exchange, you can sell your $1 million property. Then, through your qualified intermediary, you can buy vacant land for $100,000 and use the remaining $900,000 to build a property to your precise specifications.

What’s the catch? There isn’t one, although like a conventional 1031 exchange, an improvement 1031 exchange must follow strict rules and timelines. 

You can pull off an improvement 1031 exchange with the guidance of an experienced qualified intermediary. 

NEED A QUALIFIED INTERMEDIARY? Contact us today for a free, no obligation consultation.

Is an improvement 1031 exchange the same as a construction 1031 exchange?

Yes. An improvement 1031 exchange is also known as:
  • A build-to-suit exchange
  • A construction 1031 exchange
  • A rehab 1031 exchange

Rules and requirements of an improvement 1031 exchange

An improvement 1031 exchange is a type of 1031 exchange, so it’s subject to many of the same rules and timelines as the more common deferred 1031 exchange. However, keep in mind  some crucial differences or risk losing your tax deferral benefits.

🛖 Conventional deferred 1031 exchange🏡 Improvement 1031 exchange
45 days to identify a replacement property45 days to identify a replacement property and provide detailed construction plans
Must close on replacement property within 180 days for full tax deferral benefitsMust complete all construction on replacement property within 180 days for full tax deferral benefits
An exchange accommodation titleholder (EAT) will hold onto the title during the exchange periodAn exchange accommodation titleholder (EAT) will hold onto the title and pay your contractor during the exchange period
In a reverse 1031 exchange, the replacement property is purchased first, possibly with the assistance of a lenderIn a reverse improvement 1031 exchange, the replacement property is purchased first and the construction is funded with money from a lender, which can be difficult to acquire
Any leftover sale proceeds are classified as boot and will be taxableAny construction that isn’t completed by the end of the 180-day period will be considered boot and will be taxable
The finished, improved replacement property must have a value (purchase price + improvements) equal to or greater than the sale price of the relinquished property

As you can see from the above chart, an improvement 1031 exchange is more complicated than a conventional 1031 exchange. 

The best way to approach an improvement 1031 exchange? Consult with an experienced qualified intermediary. Contact us today for a free, no obligation consultation to find out your best path forward.

Examples of improvement 1031 exchanges

Rules and timelines can feel abstract on their own, so let’s look at a pair of examples to demonstrate how the rules of an improvement 1031 exchange work in practice.

Delayed improvement 1031 exchange

Let’s say an investor owns a multi-family apartment building valued at $2 million.

The investor wants to sell this apartment building and replace it, via a 1031 exchange, with an apartment building on the other side of town of the same approximate value. But after an extensive search, the investor can’t find a property that meets his specifications.

However, the investor did find a multi-family building valued at $1.25 million that would be ideal with $750,000 of improvements. Projected timeline for those improvements: about 150 days.

The investor contacts a qualified intermediary (QI) to initiate an improvement 1031 exchange, submits detailed information about the replacement property and the construction plans, and the QI sells the $2 million apartment building. 

The qualified intermediary purchases the replacement property with the sale proceeds, and places the title with an LLC or exchange accommodation titleholder (EAT) that holds onto the title of the property during the exchange. The EAT pays the contractors for the construction out of the remaining sale proceeds.

At the end of the 180-day period, the EAT transfers the title of the replacement property to the investor. As long as the construction was completed within the 180-day period, and the improved replacement property is appraised at $2 million or more, the investor can fully defer capital gains from their sale of the relinquished apartment building.

What happens if you aren’t able to complete the planned construction in 180 days?

It’s fine, actually. Your 1031 exchange is still valid. However, only the portion of construction that’s completed during the 180 days is tax free. The rest will be taxable.

In the above example, if you’re only able to complete $500,000 of construction before the end of the 180 days, you’ll have to pay taxes on the remaining $250,000 of construction.

Reverse improvement 1031 exchange

A reverse improvement 1031 exchange is when your qualified intermediary (QI) buys the replacement property first, carries out improvements, and then sells the property being relinquished.

While this arrangement provides the investor with flexibility, it also requires a lot of money upfront and some complicated financing.

Let’s say an investor owns a $2 million office building. They spend several months looking for a suitable replacement, and finally find an office building valued at $1.5 million that would be ideal with $500,000 of improvements.

The investor contacts a qualified intermediary and initiates a reverse improvement exchange. The QI purchases the replacement property; the investor now has 180 days to complete construction and sell the relinquished property. 

✍️ Editor’s tip: This isn’t always worrisome, since the relinquished property can often be sold quickly by pricing it below market, if necessary.

The QI places the title for the replacement property with an exchange accommodation titleholder (EAT), which holds onto the title for the duration of the exchange, and also pays for the construction. 

How does the EAT pay for the construction, if the initial property hasn’t been sold yet? Funds for construction are often borrowed from a lender, although this can be difficult to secure in a reverse improvement 1031 exchange. Some investors turn to private hard money lenders for a construction loan. In this case, let’s say the construction is financed with a $500,000 hard money loan. 

At the end of 180 days, or when the value of the replacement property is equal to the relinquished property, the EAT will transfer the title of the replacement property to the investor. As long as the construction was completed and the initial property was sold within 180 days, the reverse improvement 1031 exchange will be complete. The investor will reap full tax deferral benefits.

The pros and cons of an improvement 1031 exchange

An improvement 1031 exchange offers some amazing advantages, but also comes with a few downsides. Let’s compare the good and the not-so-good.

✅ Pros of an improvement 1031 exchange❌ Cons of an improvement 1031 exchange
Can buy a replacement property of any valueAn improvement exchange costs more than a conventional 1031 exchange
If you’re building from the ground up, you’ll be able to build your ideal propertyCould be difficult to complete all construction during the designated 180 day period
You’ll be able to use exchange funds for construction, instead of a more costly loanAny construction that isn’t completed during the 180-day period will be considered boot and will be taxable
Construction doesn’t necessarily have to be completed during the 180 day period

Improvement 1031 exchange planning checklist

Doing an improvement 1031 exchange involves a long, complicated process, and you’re going to need the guidance of a professional. Here’s a checklist of keysteps.

Get in touch with a qualified intermediary before you sell your property.

✅ Identify a replacement property and make sure it qualifies as like-kind. Note: 1031 exchanges are for rental, investment, and business properties — not personal properties.

✅ If you’re doing a reverse improvement 1031 exchange, identify funding from a mortgage lender or a private hard-money lender.

✅ Assess whether the construction can be completed within 180 days. Remember, engineering and architecture fees, permit fees, and lawyer and CPA fees can all be reimbursed tax-free.

✅ Once your construction plans are finalized, make sure they’re submitted to your qualified intermediary before day 45 of the process. You’ll also need to submit a detailed description of the property and location.

✅ Once construction is complete, make sure the improvements are similar to what was outlined in your plans submitted during the 45-day identification period.

An improvement exchange can be challenging, but it can be a lot easier if you’re working with an experienced qualified intermediary. Contact us today and we’ll help you find the perfect qualified intermediary to steer your 1031 exchange to success.

Improvement 1031 exchange FAQs

During an improvement 1031 exchange, can you use 1031 funds to build on a property you already own?

Short answer: yes. Long answer: it’s complicated.

In order to use improvement 1031 exchange funds to build on a property you already own, you’ll have to arrange a series of long-term leases. Under the rules of the improvement 1031 exchange, improvements made to a lessee’s property aren’t, technically, their own.

If you’re thinking of attempting this kind of improvement 1031 exchange, work with a qualified intermediary who has experience with this specific type of exchange.

How do you submit your improvement plans during the 45-day period of an improvement 1031 plan?

According to the tax regulations governing improvement 1031 exchanges, you’ll need to provide to the IRS “a legal description … for the underlying land and as much detail … regarding construction of the improvements as is practicable at the time identification is made.” 

You should provide as much detail as possible. At the minimum, you’ll need to identify the location of your replacement property, the construction blueprints, architecture diagrams, and the projected construction costs.

For example, your note might look like this: “Buying the single family home at 1234 Broadway, Austin, TX 78704, and converting the 2nd and 3rd stories to a separate unit; also building a kitchen on the 2nd level. Blueprints attached; Total projected construction costs: $250,000.”

This information, and the blueprints, are usually attached to the 45-day identification letter, which is compiled and signed by the taxpayer and delivered to the QI by the end of the 45th day. 

How do I negotiate the construction contract during an improvement 1031 exchange when I don’t own the property?

The contract will be in the name of the LLC or exchange accommodation titleholder (EAT) that your qualified intermediary sets up to temporarily “park” the title of your property. 

The EAT will name you “construction manager” so you can supervise and negotiate the construction. Funds for the work will be drawn, at your direction, from the exchange account, but the EAT will make the actual payments.

How do I work with a construction lender during an improvement 1031 exchange process?

Most construction lenders have plenty of experience working on improvement exchanges. 

During construction, you and your general contractor will work up a draw request. This document shows the current state of construction, as well as running costs. 

After this draw request is approved by you and your qualified intermediary, it’s sent to your lender, who will then pay the needed funds to your general contractor.

Can I use an improvement 1031 exchange on vacant land?

You can use an improvement 1031 exchange on vacant land if you’re going to use that property for investment, trade, or business. That can include renting, leasing, or capital appreciation. The property doesn’t necessarily need to generate income for it to qualify as “held for investment.”

However, you can’t use an improvement 1031 exchange if you’re planning on using the property as your primary residence, or if you’re planning on flipping it after building the improvements. 

What if I don’t complete all planned construction during the 180-day period?

This isn’t uncommon.  Construction runs into all kinds of delays. Any construction you don’t complete during the 180 days will be classified as boot, and it will be taxable. 

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