Structuring 1031 Exchange with improvements
Adding necessary improvements into your 1031 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.
A 1031 exchange is a section of the Internal Revenue Code and a Treasury Regulation that allows the deferral of recaptured depreciation, federal, state and local capital gains taxes when property held for the proper intent is sold and replaced within 180 calendar days. Taxes can add up to 40 percent of the property sales price. The code applies to real, tangible and intangible personal property. Examples of real and personal property include any type of real property from land, single family residential rentals, condominiums, commercial, oil and gas royalties to fractional interests in commercial properties. Personal property ranges from gold and silver bullion, aircraft, livestock, vintage cars, heirloom musical instruments, artwork, numismatic coins and construction equipment to fishing permits, commercial landing and departure rights, patents, copyrights and sports contracts.
Improvement Exchange Requirements
Depending on the type of exchange you are in: Construction vs Delayed exchange, care must be taken to ensure that these repairs are use within the IRS rules.
- In a Construction exchange: Repairs can be made to the replacement property using the exchange proceeds, given the property is owned by an Exchange Accommodator Titleholder (EAT). An EAT is a single member limited liability company that enters into a Qualified Exchange Accommodation Agreement and other exchange agreements to pay the approved contractor invoices. Either before the 180th calendar day or by the 180th day post the old property closing, the improved property is conveyed to the taxpayer. A warranty deed is created, signed, notarized and recorded with the County Clerk of Court for real property.
- In a Delayed exchange: Improvements must be made before the closing. At the replacement property closing, the contractors are paid for work completed as itemized expenses on the settlement statement and not for future services. Most Sellers will not allow this and most Buyers don’t want to commit to improvements before they own the property. But it can be done with some careful planning.
As implied, exchange proceeds cannot be used to pay for repairs after the closing unless the closing is set up as a Construction exchange. Given real property is sold, then real property must be the replacement property and not materials and labor. Appliances not firmly affixed to the property is considered personal assets and does not meet the IRS requirement.
The following example illustrates how a Construction exchange would be a viable option.
The Exchangor owns a 10-unit apartment building valued at $2 million, with $500,000 in debt on the property and $1.5 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 $1.5 million and the Exchangor estimates the improvements will cost $500,000. The Exchangor will finance the improvements with a $500,000 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.
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 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.
What is to prevent the taxpayer from having a contractor paid at closing for work to be done? Hopefully, the QI will let the taxpayer know that should their tax return be audited the IRS will quickly determine the incorrect use of the exchange funds. A penalty may be due, not to mention the tax and interest on the tax to be paid in addition to the time and effort involved with the audit, is not worth it.
Wai-Yew Lam, President
TREC Certified Instructor
Adelphi Retirement Management,LLC.