Yes, You Can Use 1031 Exchange Funds to Improve Your Replacement Property

Many people are familiar with the “law of fixtures”. In general, when an item of personal property becomes affixed to a parcel of real estate, that personal property is transformed into real property. For example, a cabinet is personal property in the home improvement store. When you bring it home and install it on your kitchen wall it becomes a fixture, and thus real property.

It seems logical, then, that improvements to a replacement property must be like-kind property. But not so fast…

When it comes to tax-deferred exchanges, timing is everything. Once the Exchangor takes title to the replacement property, the exchange is completed. Subsequent improvements will not qualify for tax deferral, even if the funds come from the sale of the relinquished property.

Exchangors often ask if they can use exchange funds to purchase materials that will not be installed in the replacement property until after the closing, or pre-pay for construction services that will be performed at a future date. The answer in both cases is “no”, even if the payments are disbursed through escrow as part of the replacement property acquisition.

Here is the reasoning. The exchange begins when the Exchangor transfers real property. If the Exchangor receives real property plus materials and/or construction services in return, only the real property is like-kind. To qualify for tax-deferred treatment, the materials have to be real property (i.e. affixed) at the time the Exchangor acquires the replacement property. Similarly, any construction services performed on the replacement property must be completed prior to closing. Reg §1.1031(k)-1(e)(4).

So what can be done? One possible solution is to ask the seller to make the improvements prior to closing, in exchange for a higher selling price. The purchase contract can be structured so that the Qualified Intermediary pays exchange funds to the seller as additional earnest money deposits or as direct payment for the improvements.

If the seller will not cooperate, the alternative is an improvement exchange. Similar to a reverse exchange, an improvement exchange requires that a third party take title to the replacement property. The third party should not be someone who is a related party to the Exchangor under the deferred exchange regulations. This deal structure gives you a cooperative seller who can make the desired improvements before the end of the exchange period.

In most instances the transaction will be structured in accordance with Rev. Proc. 2000-37. The Qualified Intermediary, or an affiliate, acquires the replacement property through a single member limited liability company (i.e. Exchange Accommodation Titleholder or “EAT”). The purchase price may be paid using exchange funds, obtaining a loan to the EAT from a bank or the Exchangor, or some combination thereof.

If improvements are going to be constructed, care must be taken to ensure that the replacement property is properly identified. It is not enough to simply identify the underlying real property. The improvements should also be identified, especially if they will be extensive enough to change the basic nature or character of the property. The exchange will qualify even if the improvements are not completed prior to the end of the exchange period.

Improvement exchanges involve higher transactions costs and cooperation from any third-party lenders. Additionally, a recent clean Phase I environmental report may be needed before the EAT takes title to the replacement property. An improvement exchange requires careful planning, but a properly structured improvement exchange will enable an Exchangor to get the desired property, along with the maximum in tax deferral. Please contact your local First American Exchange office for more information.

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