1031 Improvement Exchanges: Tax-Efficient Property Upgrades
Did you know that you can use a 1031 exchange as a strategic way to enhance property value with improvements while deferring taxes? It’s called a 1031 improvement exchange and lets you use some of the proceeds from the sale of a relinquished property to make rehabilitations and renovations to a replacement property. This guide will help you know how to allocate exchange funds effectively in a way that not only improves the property, but also lets you defer capital gains tax.
What is a 1031 Improvement Exchange?
Traditional 1031 exchanges let you sell a property that you own for business use or investment purposes, and use the proceeds from the sale to buy a like-kind property without paying capital gains taxes. Reverse 1031 exchanges reverse the process: they are for when you buy a replacement property before you have closed on the sale of your relinquished property.
A 1031 improvement exchange adds another layer, letting you use funds from the sale of your relinquished property for improvements on a like-kind property. If the value of the replacement property is less than the one you sell, improvements can be used to increase the value enough to meet the requirements for full deferral of capital gains taxes. Improvement exchanges can be either traditional or reverse exchanges.
Benefits of Improvement Exchanges
One tremendous benefit of a 1031 improvement exchange is that it lets you use pre-tax dollars to increase the property value of your new, replacement property through enhancements to existing structures. This allows for significant property appreciation.
The proceeds from the sale of your relinquished property that are used toward the acquisition and improvement of your replacement property, as well as those proceeds that are paid or used for the improvements, will qualify for tax deferred exchange treatment provided the transaction is properly structured as a 1031 improvement exchange.
Detailed Process for a 1031 Improvement Exchange
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Contact 1031 Pros for advice on structuring your 1031 improvement exchange.
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Because Section 1031 does not allow you to own both properties at the same time, you will sell the relinquished property through a qualified intermediary and Exchange Accommodation Titleholder (or EAT), or in some cases acquire the replacement property first through a parking agreement.
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As your qualified intermediary, we will set up a special purpose entity, often a single member limited liability company, that is used to acquire and park the title to your replacement property during the exchange.
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We will work with you to use exchange funds to improve the replacement property.
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At the end of the exchange, the replacement property and any construction loans will often be transferred to you through the holding entity, rather than by a deed. We will work with you to ensure compliance with all tax and other legal issues.
Regulatory Guidelines and Compliance
All of the proceeds from the sale of your relinquished property must be used to acquire and improve the replacement property, in order to qualify for tax deferral.
Also, you must adhere to a strict timeline: there is a 45-day timeline for identifying a replacement property and a 180-day timeline for completing the exchange. If you miss these deadlines, you are responsible for paying capital gains taxes on the sale of your relinquished property. At 1031 Pros, we will help you navigate the complexities of exchanges successfully.
Project Planning and Execution
As with all construction and renovation projects, there can be costly delays. It is important to plan for these and work closely with your contractors and vendors in order to make sure that the 180 day deadline is met. This means reviewing plans, specs, and project documents, going over every detail of the scope of work.
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It is also helpful to create and coordinate a master schedule with all parties and refer to it often, modifying it as needed, and implementing contingency plans that you have put in place. From there, communication and collaboration are key! You want to get regular updates on progress, monitored and documented, to ensure that you meet the deadline.
Financial Considerations and Risk Management
Improvement 1031 exchanges can be more complicated and costly than traditional 1031 exchanges, so be aware of the amount of depreciation recapture and capital gains tax liabilities that are being deferred, to ensure that the cost of the improvement exchange is worthwhile.
To fully defer capital gains taxes, all of the exchange equity must be invested in products and services on the new property; any unused funds are taxable. Exchange funds that have been placed in escrow for post-closing improvements do not qualify, even if the funds are deposited before you take the title.
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If the exchange funds do not cover the acquisition and improvement of the new property, additional funds can be loaned to 1031 Pros as your qualified intermediary and Exchange Accommodation Titleholder (EAT). If you need a construction loan from an institutional lender, you should seek lender approval prior to starting the exchange. You can also partner with your developer, using a construction reserve in the exchange account.
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Acting as project manager for the construction, you will send invoices to 1031 Pros, as your EAT, to be paid directly to your vendors. During the exchange period, you cannot be reimbursed for any advances or expenses incurred. As you are allocating a budget for the construction project, always be aware of potential cost overruns!
At every step of the way, 1031 Pros is here to help.
Choosing Properties Suitable for Improvement Exchanges
Before entering any real estate transaction, you will want to look at the economic stability of the area where your replacement property is located, as well as gauge local demand for the type of your improvement project. Finding a property in a high-growth area is ideal, as well as one that allows significant value-add through the improvements, or even one that is under market value with high upside potential. It’s important to understand market trends and future growth potential, and we’ll work with you to help make sure that you select the right replacement property.
Call Us for a Free Consultation
Our customer service is unmatched in the industry, including a live person answering the phone when you call at any time, 24/7, and responses to emailed questions within 24 hours. Contact us at 916-252-6900 for a free consultation before starting your 1031 improvement exchange, or even to discuss long-term strategies for your portfolio, to ensure that you are set up for success.
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