Real estate has long been a popular investment avenue for individuals and businesses. However, the tax implications of buying and selling property can sometimes deter potential investors. This is where a 1031 exchange comes into play, offering a way to defer capital gains taxes and continue building wealth through real estate investments. While many are familiar with the concept of a 1031 exchange, not everyone is aware of its variations, including the improvement 1031 Exchange. In this blog post, we’ll explore what an improvement 1031 exchange is and how it differs from other types.
An Improvement 1031 Exchange, allows a client to include improvements to the replacement property as part of the exchange. To be included, the improvements must be considered “real estate” (as that term is defined by the Internal Revenue Code and applicable State law).
The client can pay for the improvements using funds held by the qualified intermediary; funds from the client; a lender; or some combination of all three.
An improvement exchange can take one of two forms:
In this instance the client has closed on the sale of the relinquished property and wishes to make improvements to the replacement property, possibly as a means of increasing the value of the replacement property for exchange purposes. For example, if the client intends to purchase the replacement property for $100,000 and add $25,000 of improvements, the value for purposes of the exchange would be the total amount of $125,000.
Similar to a Forward Improvement Exchange, the Reverse Improvement Exchange refers to a situation where the client will acquire the replacement property prior to closing on the sale of the relinquished property. Improvements are made to the replacement property as part of the reverse exchange.
Both the Forward Improvement and Reverse Improvement exchange strategies rely on the authority set forth in the safe harbor found in Rev. Proc. 2000-37. The safe harbor authorizes the improvement exchange concept. The concept uses an Exchange Accommodation Titleholder or “EAT” (also sometimes referred to as a Facilitator) to facilitate the addition of improvements to the replacement property. The EAT will typically be a single purpose entity (such as a limited liability company) formed specifically to facilitate the exchange. The EAT will take title to the replacement property under the terms of a qualified exchange accommodation agreement and hold it during the period the improvements are constructed.
An improvement exchange which utilizes the safe harbor will require the use of an EAT. The EAT must be in place prior to making any intended improvements. Make sure you discuss this aspect of the exchange with your advisor prior to closing on the sale or purchase or constructing any improvements on the real estate.
Improvements which are intended to be included as part of the exchange must satisfy two conditions:
- They must be considered “real estate” once completed;
- The improvements must be completed within the exchange period.
If the client is engaged in a forward improvement exchange, the improvements must also be included within the description of real estate submitted within the identification period. Often one of the challenges in completing an improvement exchange is the ability to complete most or all of the intended improvements within the exchange period.
Getting the intended result starts with creating the proper strategy. It’s important to make sure your team has the experience and expertise to arrive at the desired result. The 1031 Exchange Intermediaries team has over 25 years of experience helping clients minimize tax liabilities allowing clients to maximize their return on investment. Our knowledge allows us to keep your improvement exchange on target.
Contact us today to learn more about our 1031 exchange services.