One way to make sure the replacement property in your 1031 exchange suits your investment needs is to alter it. This was challenging before the IRS created the exchange accommodation titleholder (EAT), since materials and labor cannot be part of the exchange itself. But now you can use a 1031 improvement exchange, otherwise known as a construction or build-to-suit exchange, not only to defer capital gains taxes and depreciation recapture, but also build, renovate, or customize your replacement property before the exchange is finalized. The 1031 improvement exchange can be a valuable tool for avoiding cash boot as well.
Use a 1031 Improvement Exchange to Get a Better Replacement Property
An EAT is a special purpose entity created and controlled by your qualified intermediary (QI) and structured as an LLC. It can facilitate a 1031 improvement exchange by independently commissioning improvement work on your replacement property and holding your replacement property for the duration of the work, thus avoiding receipt or constructive receipt of funds.
In a delayed improvement 1031 exchange, that is, a 1031 improvement exchange using the simplest exchange procedure, the relinquished property is sold and the proceeds are transferred to the EAT. The EAT then purchases the replacement property, which is generally referred to as “parking” the property, and orders the work on it. The replacement property can be an existing structure that is to be altered or bare land that will be used as a construction site. This is a very investor-friendly provision, as the investor may act as the contractor for the improvements or lease the property from the EAT while it holds it.
An EAT is always used in a reverse 1031 exchange when the replacement property is purchased before the relinquished property is sold. In reverse improvement exchanges, funds have to be injected into the transaction to finance the improvements. The taxpayer is allowed to lend money to the EAT for that purpose. A bank can make the loan as well. Those funds are repaid at the end of the transaction.
Another benefit of the 1031 improvement exchange is that it is a potential tool for preventing cash boot. To avoid an exchange in which the replacement property is of lesser value than the one relinquished, the cash difference can be used on improvements to the replacement property. While you are held to a 180-day limit for completing the exchange, there is no requirement that the new construction be completed at that time.
Having said that, the real property of the replacement property does need to be equal to or greater than the relinquished property by the end of the 180-day closing period. In other words, the capital improvements or new construction to a property need to be performed within the 180-day period, which results in real property as opposed to non-real property funds that have been earmarked for capital improvements. For example, if you sold a property for $2 million and you did a 1031 improvement exchange into a parcel of land that you intended to build $3 million of real property on, then you need to complete at least $2 million of real property construction within the 180-day closing period.
A 1031 Improvement Exchange Is More Complex for the QI
A 1031 improvement exchange is considerably more complex than a regular delayed exchange and more demanding of the QI. Not every potential QI will be able to facilitate an improvement exchange, so the investor should ask in advance about the QI’s experience and knowledge of the procedure.
Also, keep in mind that, because of the complexity, a 1031 improvement exchange has higher QI fees than a typical exchange, as well as other expenses, such as costs for setting up the LLC. When budgeting the improvements, be sure to take the full cost of the exchange into account and balance it carefully against the tax deferment and depreciation recapture to avoid unnecessary expenses.
A 1031 improvement exchange is a valuable tool with wide applications for real estate investors. When used in conjunction with a capable QI, it gives you the opportunity to create the best possible 1031 exchange—both in terms of its size and the replacement property you receive.
At CWS Capital Partners, we are a fully-integrated multifamily real estate investment management firm that offers everything from due diligence and risk management to transaction support and property management. We specialize in assisting our clients with 1031 exchanges, acquisitions, repositioning, and development. We own and manage luxury multifamily investment communities in major markets around the country, and we employ a team of experts who can help you hone your investment strategy.
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