Real estate investors may be surprised to learn there are four different types of 1031 Exchanges. By far, the most common is the “Delayed Exchange”, but this isn’t always the right fit for an investor’s needs. Sometimes, the “Replacement Property” needs some work and, when it does, an Improvement Exchange may be a better fit.
In this article, we are going to discuss 1031 Improvement Exchanges. We will describe what they are, how they work, the requirements for completing one, and the advantages/disadvantages of them. By the end, readers will have the information needed to determine if this unique type of transaction is a good fit for their own needs.
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers and often assist investors with the placement of their 1031 Exchange funds. If you are an Accredited Investor and would like to learn more about our current investment opportunities, click here.
What is an Improvement Exchange?
In general, a 1031 Exchange is a type of commercial real estate transaction that allows investors to defer capital gains taxes on the profitable sale of an investment property as long as they reinvest the sales proceeds into a new property that is “like kind” to the one sold. Given the tax deferral benefits, this is an incredibly popular program and can be an excellent way for investors to grow their capital tax free over time. To accommodate the uniqueness of every transaction, there are four types from which investors can choose.
The focus of this article is one of the four types known as an “Improvement Exchange” or “Construction Exchange” which allows investors to acquire the exact replacement property that they want by using a portion of exchange proceeds to make improvements to it.
Requirements for Completing a 1031 Improvement Exchange
Rules for the completion of an Improvement Exchange, sometimes called a “build to suit exchange,” are outlined by the IRS in internal revenue code. They include:
- Investors have 45 days from the sale date of the relinquished property to identify a suitable replacement property and 180 days to close on the purchase of it.
- Both the relinquished property and the replacement property must be titled the same way
- The replacement property must be like kind to the relinquished property. In general, all commercial properties are like kind to other commercial properties. For example, an office building is like kind to a multifamily apartment building.
- The market value of the replacement property must be equal to or greater than the value of the relinquished property.
- All improvements to the replacement property must be completed within the 180 day exchange period
- The replacement property cannot be acquired and held directly by the taxpayer while improvements are being completed. Typically, it is acquired by a Qualified Intermediary or Exchange Accommodation TitlehHolder, and then transferred when improvements are complete.
- Once the improvements are complete, the property must still meet the like kind test.
There are other rules that must also be met, which highlights the need to use a Qualified Intermediary to complete the exchange transaction. These are complex deals and making a mistake can prove to be very costly.
When To Use An Improvement Exchange
In theory, an Improvement Exchange could be completed any time an investor wishes to do one. But, the most common scenario for one is when a replacement property needs to be updated or configured for a specific use.
For example, suppose a small manufacturing business has outgrown their space and they are looking for a new building to accommodate future growth. But, to occupy the new building, there are improvements that must be made to accommodate their equipment and growing staff.
So, in an improvement exchange, the company may sell their existing property and use some of the proceeds to make the required improvements in the new property. But, they must be completed by the 180th day after the sale date to comply with IRS rules.
How Does a 1031 Improvement Exchange Work?
To illustrate how a 1031 Improvement Exchange works, let’s continue the example from above.
Again, suppose a small manufacturing company that has outgrown their current space and is looking to move into a new building with additional room to grow. Because they have a significant profit locked into the sale of their current space, they have determined a 1031 Exchange is their best course of action. And, because the replacement property needs improvements to meet their needs, they have determined an Improvement Exchange is the right type.
With this scenario in mind, let’s review how this transaction would work.
Step 1: Hire a Qualified Intermediary and Sell The Property
Once they have decided on an Improvement Exchange, the very first thing a company should do is to hire a Qualified Intermediary to help facilitate the transaction and notify them they intend to complete an improvement exchange.
Next, they should hire a broker and put the property up for sale. Hopefully, the broker will locate a buyer quickly, negotiate a favorable price, and get the sale closed – with the stated intent of completing a 1031 Exchange. Because the transaction involves an Improvement Exchange, some special paperwork may need to be executed at closing to transfer ownership of the property to a federally insured bank designated by the Qualified Intermediary.
Step 2: Locate a Replacement Property and Negotiate The Purchase of It
Once the sale of the relinquished property is complete, the next step is to locate the replacement property. So, the company would work with their broker to find a property that is going to meet their needs. They have until midnight of the 45th day to formally identify their replacement property and it must be done in writing with a description of the planned improvements. NOTE: In many cases, the replacement property is identified before the relinquished property is even sold.
Once identification is complete, the company should close as quickly as they can on the purchase of the replacement property. Again, there may be some specific documents that need to be signed indicating the purpose of the acquisition is for a 1031 Exchange and that there are improvements planned during the exchange process.
Step 3: Execute The Improvements
Once the purchase complete and the property is transferred to the Exchange Accommodation Titleholder, improvements and renovations can commence. But, they must move quickly. Improvements must be complete by the end of the 180-day period so it is unlikely that anything major can be done. In addition, there is a requirement that the property must be like kind, so a grand renovation or ground up new construction is not likely to meet this test.
To continue the example, the company would make all of the necessary improvements. For example, maybe they would build new offices or reinforce the structure of the property to accommodate manufacturing equipment.
Once the improvements are complete, the Exchange Accommodation Titleholder transfers title of the replacement property/improved property to the company and the exchange is complete.
Types of Improvement Exchanges
The Improvement Exchange can be completed in “forward” or in “reverse.”
Improvements in a Forward Exchange
This type of Improvement Exchange is the one described above. In it, the old property is sold first, and the new property is then found and improvements are made to it. Once complete, the property is transferred to the ultimate owner and the exchange is complete.
Improvements in a Reverse Improvement Exchange
As the name suggests, this transaction happens in reverse. So, the replacement property is purchased first and the improvements are completed and then the relinquished property is sold. This may happen in a scenario like the one described above, where a company is moving to a new facility and they need for it to be completed before they vacate the old property. In addition, they need to continue to occupy the old property until the new one is ready.
Improvement Exchange Fees
Given the complexity of this type of transaction, there are a number of advisors and experts that must be involved to make sure it is fully tax-deferred – including Qualified Intermediaries, title agents, attorneys, lenders, closers, appraisers, and escrow agents. They all charge fees for their services. Below is a summary of the fees an investor can expect in a tax-deferred improvement exchange:
- Appraisal: Fee charged by third party appraiser to provide an estimated value of the property. The cost can be up to $5,000 or more.
- Attorneys Fees: Fees charged by attorneys to review contracts and provide advice to ensure all laws are complied with. Depending on the purchase price of the replacement property, these fees can be in the hundreds or well into the thousands for more expensive assets.
- Broker’s Commissions: It is likely an investor will have to pay broker commissions on the sale side, usually somewhere in the 4% – 8% range. If they use a broker to purchase a new property, that broker’s fee is paid by the seller of that property.
- Escrow Fees: There may be some amount of exchange funds that have to be held in escrow for the duration of the exchange process. They are usually equivalent to 1% -2% of the sales price of the relinquished property.
- Transfer Taxes: Fees paid to complete the transfer of the title from the seller to the buyer. They are typically around 2% of the property’s value.
- Inspections: A fee paid to a third party property inspector to make sure that the new property is structurally safe.
- Title Insurance: A fee paid to a third party title insurance company to ensure there are no issues with the chain of title from one owner to the next.
- Qualified Intermediary: Finally the Qualified Intermediary charges a fee for their role in facilitating the transaction. It can range from a few hundred to a few thousand dollars depending on the size of the transaction.
The actual fee types and amounts may vary from those described above. But, the key point to remember is there are a lot of fees and they should be accounted for when planning for the exchange. Or, to put it another way, investors should consider the amount of taxes they would be required to pay if they did not do an exchange versus the fees associated with the exchange to ensure it is in their best interest.
Advantages of a 1031 Improvement Exchange
Clearly, the major advantage of a 1031 Exchange in general is the indefinite deferral of capital gains taxes. This may provide moderate savings in one deal, but 1031 Exchanges can be completed over and over allowing an investor’s capital to grow tax deferred over time. This is a major savings. But, there are two other benefits worth mentioning as well.
First, a property owner gets the chance to use part of their exchange proceeds to customize a property for their specific needs. For example, they could build out an office, a retail storefront, or renovate a group of apartments.
The other notable benefit is they get to access some of their exchange proceeds tax free. In a traditional exchange, investors have to reinvest all of their gain into the new property. In an improvement exchange, they get to use tax free dollars to make property improvements.
Drawbacks of a 1031 Improvement Exchange
The major drawback of an improvement 1031 Exchange is it has to happen fairly quickly. Remember, investors have just 45 days to identify the replacement property and all improvements must be completed by 180th day. This is a relatively short time frame and any major delays can put completion of the improvements in jeopardy. For this reason, the scope of the improvements must be somewhat limited.
The other drawback to consider is the complexity of the deal. There are many moving parts and many rules that must be followed to get it done correctly. If any are broken – for example if the taxpayer receives any personal property in the exchange – internal revenue service rules state this portion of the exchange could become taxable. So, it is important for investors to move deliberately and follow the rules to make sure they receive full tax deferral.
Investing Through Private Equity Real Estate
A private equity firm is an investment company that allocates capital to the privately held equity of other companies – including those that own real estate. As a private equity commercial real estate investment firm, we are often called upon to help our clients place their 1031 Exchange funds, which we do through a structure known as Tenants in Common. These rarely involve improvements, so they may not be the best fit for investors who need them. But, for investors looking for a more traditional tax-deferred exchange they can be very beneficial because the transactions are relatively painless and we do all of the hard work on the investor’s behalf.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We utilize our liquidity and decades of experience to find multi-tenanted, world-class investment opportunities for our partners.
If you are an Accredited Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.