What Are Improvement Exchanges? IRC Section 1031 Exchange

This has been a topic we are receiving more and more questions on from clients...

An Improvement Exchange allows the investor to construct the “perfect” replacement property in order to acquire precisely what is desired. Improvements can be as simple as repairs to existing structures or as complex as ground-up new construction. The Improvement Exchange opens up many opportunities to the savvy investor, even the possibility of improvements to property already owned.

IMPROVEMENT EXCHANGE REQUIREMENTS

1031 Exchange requirements must be applied in the Improvement Exchange. This requirement means that all improvements must be constructed within the 180-day time period. With this time constraint, satisfying the “like-kind” requirement may be challenging. When the Exchangor gives up real property, he needs to receive real property in return. If at the 180-day deadline the Exchangor were to receive only unimproved land with labor and materials to be used in the future, the exchange would?not?be totally tax-deferred. The labor (services) and materials (personal property) are not like-kind to real property. While escrow holdbacks or pre-payment of labor and materials are natural paths in getting improvements done, they do not qualify for tax deferral. The escrow holdbacks and pre-payment of labor and materials are treated as “boot” and are subject to taxation.

The exchange value requirement (Napkin Test) must also be met in the improvement exchange. When the improvements to the replacement property are completed, the replacement property needs to have the same or greater value than the relinquished property.

The following example illustrates how the improvement exchange would be a viable option:

The Exchangor owns a 20-unit apartment building valued at $1.7 million, with $700,000 in debt on the property and $1 million in equity. The Exchangor wants to acquire a medical office building downtown. The type of building the Exchangor wants is currently not available for sale. Fortunately, there is a property for sale in the desired area that has a small vacant retail building on it that can be improved and expanded for office medical suites. The property is available for $1 million and the Exchangor estimates the improvements will cost $700,000. The Exchangor will finance the improvements with a $700,000 construction loan. The Exchangor estimates the improvements to take 5 months and that the value of the improved medical building, when appraised, will be at least $2 million. In this example, the improvement exchange works. The exchange is completed within 180 days and there is an exchange of like-kind property. The value of the improved replacement property (value, debt and equity) are the same as or greater than the relinquished property.

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