1031 Exchanges Involving Construction and Property Improvements

1031 Exchanges can be utilized in transactions where construction or improvements are desired on the Replacement Property. If an Exchanger sells the Relinquished (old) Property for a higher value than the purchase price of the property to be acquired, referred to as the Replacement (new) Property, the left-over funds would be considered “boot” and fully taxable. An attractive alternative to a taxable event is to utilize the excess funds to make improvements or build from the ground up on the new property, known as an Improvement, Construction, or Build-to-Suit Exchange.

Improvement Exchanges arise in two different ways. The first scenario is where the client has sold the old property, and identified a potential new property that would result in leftover funds, and the Exchanger wants to use those funds towards improving the new property from ground up or improvements to the existing property. The Improvement Exchange can include not only the improvements, but the value of the land purchase as well. The other variation takes place where the taxpayer wishes to acquire the new property and begin the improvements before selling the old property. This scenario may be used if there are weather factors requiring improvements to be completed as soon as possible or for a business to relocate in which the new property is needed as soon as the old one is sold. This version is “reverse” in nature since the new property will be acquired before the old one sells.

The IRS Section 1031 involves trading “like-kind” real estate. However, once an Exchanger acquires the new property, any improvements made after the acquisition constitute payment for labor and materials, and those payments would not constitute receipt of “like-kind” real estate. The IRS has provided rules on how to structure such a transaction so that improvements could be completed with exchange funds prior to acquiring the new property. If structured the way the IRS recommends, the Exchanger will meet the “safe harbor” provided for under the rules. The benefit of being in the safe harbor is that the IRS is approving the structure in advance as to form.