1031 Improvement Exchanges: A Guide

1031 exchanges let real estate investors defer capital gains taxes when they buy a like-kind replacement property and sell one of their existing properties that has an equal or lesser value. But most of those exchanges focus on swapping into a property that’s ready to go. If the property needs improvements, a traditional 1031 exchange won’t work. Instead, you’ll want to explore a 1031 improvement exchange and use it to your advantage.

Let’s take a closer look at how improvement exchanges work.

What is a 1031 Improvement Exchange?

1031 improvement exchanges, or “build-to-suit” exchanges, enable investors to not only acquire but enhance replacement properties using exchange funds for capital improvement costs. This helps them maximize the reinvestment potential of their exchange proceeds while deferring as much capital gains tax liability as possible.

With these exchanges, you can use the proceeds from the relinquished property’s sale to pay for improvements to your replacement property. And if the improvements require building from the ground up, you’re still permitted to use the money to fund construction so you can build the property to suit your needs as an investor.

1031 Improvement Exchange vs. A Standard 1031 Exchange

Both 1031 improvement exchanges and standard exchanges follow the same rules and principles. This means to be eligible for an improvement exchange, you must meet the following requirements:

The property must be for investment use, not personal use.
The replacement property, including completed improvements, must be of equal or greater value to your relinquished property.
You must follow the 45-day identification period and the 180-day exchange period timelines to complete the exchange.
You must work with a Qualified Intermediary (QI).
You must notify the IRS of the exchange once it’s done.

However, there are some key differences. In improvement exchanges, the QI will hold the proceeds from the sale of your relinquished property and distribute them directly to the contractors you hire to make the improvements. Only the value of improvements completed before the end of the 180-day period will count toward the total property value for capital gains tax deferral purposes.

How Does a 1031 Improvement Exchange Work?

Though 1031 improvement exchanges work similarly to standard 1031 exchanges, they work in different ways depending on whether you’re using a forward exchange or reverse exchange. Here’s what you need to know.

Improvement Exchange Strategy With Forward 1031 Exchanges

Forward exchanges allow you to sell your relinquished property and use a portion of the money from the sale to acquire a replacement property. The other proceeds can be used to pay for repairs and improvements.

Both the funds from the sale you use to purchase the replacement property and the improvement funds are eligible for capital gains tax deferral as long as the exchange is completed on time and in line with the IRS’s rules.

This method can be a good choice when there are fewer buyers than there are properties for sale, so you can take your time and find a qualified buyer for your relinquished property before searching for a suitable deal on a replacement property.

Improvement Exchange Strategy With Reverse 1031 Exchanges

With a reverse exchange, you purchase a replacement property before selling your relinquished property. This may help you secure a great deal as soon as a qualified property comes onto the market without forcing you to wait until your relinquished property sells.

As soon as you close on the purchase, you can start making improvements to the property while the Exchange Accommodation Titleholder (EAT) holds the title. Once you sell your relinquished property and give the proceeds to the QI, the EAT transfers the title of the replacement property to you. From there, the QI will oversee the exchange and help you wrap up the process.

Just as with any exchange, you’ll need to close on the sale of your relinquished property within 180 days of closing on the replacement property.

What Are the Benefits of a 1031 Improvement Exchange?

Here are some of the benefits you may see from incorporating 1031 improvement exchanges into your investment strategy:

The ability to buy lower-value properties: In improvement exchanges, you’re able to purchase a property that has a lower value than your relinquished property that you can build on, broadening your options.
The chance to make improvements without loans: With these exchanges, you can use the proceeds from the sale of your relinquished property to pay for improvements. That means you may not need to take out loans or go into debt to get the property up to your standards.
The opportunity to defer capital gains taxes: With 1031 improvement exchanges, you’re still able to defer capital gains tax liability as long as you fulfill the terms of the exchange.

What Are the Drawbacks of a 1031 Improvement Exchange?

Though improvement exchanges can be a good option, they’re not without their drawbacks. Here are some of the downsides you may see from using this strategy:

The strict timeline: Like all exchanges, improvement exchanges must adhere to the 45-day and 180-day rules.
The potential for improvement costs not being covered by the exchange: Only work completed within the 180-day timeframe is covered by the exchange. This means any improvements made after the 180-day period will not increase the property’s value for the exchange.

Tax Implications and IRS Guidelines for Improvement Exchanges

If your exchange is successful, you’ll be able to defer the capital gains tax until you sell the property or exchange it for another like-kind property in the future. However, as we mentioned, only the improvements made within the 180-day exchange period will be subject to the exchange and thus provide the opportunity for capital gains tax deferral. This is why it’s a good idea to focus on improvements that will have the greatest impact on the property’s value first.

Before you consider an improvement exchange, it’s a good idea to speak with your trusted tax professional. They’ll help you better understand how these exchanges may help your tax situation so you can make the right choice for your needs.

Improvement Exchanges Offer Flexibility

Improvement exchanges give you the opportunity to leverage the capital gains tax deferral traditional exchanges offer while ensuring the property meets your unique requirements. But before you commit to your exchange, make sure you set yourself up for success by working with a team that understands the process.

Ready to begin? Start the improvement exchange process with First American Exchange Company.