In a strong real estate market, it can be difficult for investors to acquire the ideal replacement property due to lack of supply and strong competition. However, there may be opportunities to acquire property that needs construction work or improvements at a fraction of the price of other properties.
Investors can take advantage of these opportunities by using a 1031 tax deferred “improvement” exchange. The improvement exchange, also known as a build-to-suit or construction exchange, allows an investor to use the proceeds from the sale of the relinquished property not only to acquire replacement property, but also to make improvements to the property.
If an investor sells relinquished property with a fair market value of $1 million, debt of $200,000 and equity of $800,000, he must acquire a property equal to at least $1 million and must invest at least $800,000 into that property in order to completely defer his tax in a 1031 exchange. In an improvement exchange, however, the investor could acquire property worth only $300,000, borrow an additional $200,000 and spend the remaining $500,000 of exchange proceeds plus the $200,000 in loan funds on improvements to the property. This would use up the remaining cash and increase the fair market value of the replacement property to $1 million, resulting in a fully tax deferred exchange.
Structuring an Improvement Exchange
An improvement exchange is accomplished by having a separate entity called an “exchange accommodation titleholder” or “EAT” temporarily take title to the replacement property while the improvements are being made. The EAT is necessary because any work done to the property after the investor takes title to it is not considered like kind property and therefore will not increase the value of the property for exchange purposes. First American Exchange creates and owns this entity which holds title to the property for up to 180 days. During that time frame the investor controls the construction, not First American Exchange. The costs of construction are paid for either by the investor, a loan, or by using the funds from the sale of the relinquished property.
Benefits and Drawbacks of Doing an Improvement Exchange
The benefits of doing an improvement exchange include the ability to buy property that is lower in value compared to the relinquished property while still having a completely tax-deferred exchange, and to use exchange funds rather than loan proceeds to fund construction.
The principal drawback of doing an improvement exchange is that only the work completed within the 180 day period is applicable to the exchange. In addition, improvement exchanges can be more costly due to fees and costs of an additional closing and formation of the EAT.
Planning for an Improvement Exchange
For those intending to do an improvement exchange, planning ahead is essential.
- First, include a provision in the purchase contract that it is assignable in connection with a 1031 exchange. This is necessary because the EAT, rather than the investor, will be taking title to the replacement property.
- Contact First American Exchange and your lender early in the process. Typically the EAT signs the loan documents and the loan must be completely non-recourse to the EAT. Additionally, there may be some environmental due diligence that will need to be completed prior to the EAT taking title.
- Get an accurate estimate of the amount of time it will take to complete the construction project. Although the construction does not have to be complete at the expiration of the 180 day period, the only improvements that will affect the value of the replacement property for exchange purposes are the improvements that are done as of the date that the EAT transfers the replacement property to the exchangor.
- Finally, always consult with your tax advisor before doing any exchange, including an improvement exchange.
By properly structuring an improvement exchange, the investor should have much more flexibility in finding appropriate properties and at the same time completely defer all capital gains tax. To discuss your particular circumstances and for additional information, contact First American Exchange Company.
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