An Improvement Exchange
RC section 1031 allows investors to exchange investment property and defer capital gains tax. One of the exchange structures is called an “Improvement Exchange”. This structure makes it possible for an investor to receive property in a tax-deferred exchange that has been renovated to the investor’s specifications. As bears further explanation, this exchange must be structured and executed with care to meet IRS code rules.
The main advantage of the improvement exchange is that an investor uses “tax-free dollars” to renovate or improve a desired property. For complete deferral of capital gains taxes, the value of the replacement property (purchase price plus closing costs) must equal or exceed value of the sold property (the sales price less closing costs). Because the value of the replacement property is determined as of the date that the investor receives title, only the value of any improvements made to the replacement property prior to its conveyance to the investor may be included in its exchange value.
Therefore, using an improvement exchange, the sales proceeds from the sale of the relinquished property may be used to acquire, and improve, the replacement property without paying capital gains taxes on such proceeds.
Requirements for an Improvement Exchange
Under IRC section 1031 rules, in all tax-deferred exchanges the investor must receive the replacement property within 180 days of the date the relinquished property is sold. Also, for the value of the improvements to be included in the value of the replacement property, such improvements must be completed prior to the investor’s receipt of such property. Therefore, such improvements must be completed, and the property conveyed to the investor on or before the 180th day and not after. .
The Structure of an Improvement Exchange
Using a QI, an improvement exchange can be structured to look like this. The investor and their (QI) enter into an exchange agreement specifying the QI’s obligation to acquire certain property, improve the property to the investor’s specifications, and convey the improved property to the investor in exchange for the previously sold property. The contract to sell the relinquished property is assigned by the investor to the qualified intermediary, and the property is sold with the sales proceeds going to the qualified intermediary. The replacement property and the specific improvements to be made are often identified in the exchange agreement but can be identified up to 45 days after closing.
The contract originated and negotiated by the investor to purchase the replacement property is assigned to the QI, who purchases and takes title to such property. Afterwards, the QI and the investor coordinate improvements/construction.
The investor acts like the general contractor and takes all steps to construct the improvements. The QI is a party to the construction contracts, and jointly approves disbursements of the exchange proceeds and other construction funds.
Funding sources to purchase the replacement property and renovate it include exchange proceeds, financing from an institutional lender, and/or funds lent by the investor to the Qualified Intermediary. Financing is usually made to the Qualified Intermediary on a nonrecourse basis secured by the replacement property.
Sources of financing may also be guaranteed by the investor if required by the lender.
Upon completion of the improvements (or when the 180-day exchange period is about to expire), the replacement property is conveyed/sold by the Qualified Intermediary (QI) to the exchanger at a price equal to the acquisition cost plus the construction cost of the completed project. The exchange is final when the replacement property has been conveyed to the exchanger.
Directrust℠ 1031 exchange services (Directrust℠) performs the duties of a qualified intermediary (QI) and does not provide due diligence to third parties regarding prospective investments, platforms, sponsors, dealers or service providers. Directrust℠ 1031 exchange services does not provide investment, legal or tax advice. Individuals should consult with their investment, legal or tax professionals for such services.