A deferred improvement exchange is when the exchangor uses the exchange proceeds or funds towards making improvements to the replacement property following the first leg event or sale of the relinquished property. The only difference between a deferred improvement and a reverse exchange is the sequence of events. In either 1031 exchange, the improvements must be made while an Exchange Accommodator Titleholder (EAT) is on title. A Qualified Exchange Accommodation Agreement (QEAA) is entered into by the exchangor, EAT and the Member of the EAT qualifying for the safe harbor protection provided by Revenue Procedure 2000-37.
Rev Proc 2000-37
The safe harbor provides for the EAT to take title to either the relinquished or replacement property and park it for up to 180 calendar days, while either the relinquished property is sold or replacement property is improved. The EAT is treated by the Internal Revenue Service as the beneficial owner of the parked property in the QEAA, bearing the burdens of ownership for federal income tax purposes.
The EAT is typically a single member limited liability company (SMLLC) created by the Qualified Intermediary to park or take title to the replacement property in a deferred improvement exchange. The exchangor has a secured position in the EAT through a Pledge of Membership Interest and role defined in the QEAA.
Deferred Improvement
In a deferred improvement exchange, the old property is sold first, followed by the acquisition of the replacement property. The new property is acquired and recorded on behalf of the EAT. Per Rev Proc 2000-37, the EAT has the indicia of ownership, meaning, if the property were destroyed, the EAT is responsible. Consequently, another important step is that the EAT is added to the exchangor’s insurance policy as an additionally insured party. As the work begins, the contractor invoices are submitted by the exchangor to the Qualified Intermediary for payment or by the taxpayer. Exchange proceeds from the sale of the relinquished or old property are used towards purchasing the replacement property. Exchange funds either left over from the purchase, a bridge loan or additional equity are deposited for the qualified intermediary to pay the contractors. Insurance, taxes, architect fees and permits may be paid from the exchange proceeds.
By the 180th calendar day post-closing on the relinquished property, the replacement property is retitled or conveyed to the exchangor in a warranty deed. The improvements may not be finished. That is acceptable, though a decision is made as to the percentage complete. That percentage represents the percentage of the recognized gain or tax that is deferred in the 1031 exchange.
Material and labor are not considered real property. Consequently, materials such as floor tile or roof shingles must be affixed to qualify as real property and paid during the time the EAT is on title. The materials cannot simply be invoiced or delivered, but rather installed to qualify.
Transfer Fee or Stamp Tax
In a deferred improvement exchange when the replacement property is to be conveyed to the exchangor, the Member of the EAT can assign membership interest by changing the member of the SMLLC. The exchangor then owns the replacement property in a SMLLC. This accomplishes the transfer without triggering a state imposed transfer tax. In states where exemptions are provided, such as in Florida, Florida Department of Revenue Technical Assistance Advisement No. 05B4-006 and 07M-001 recognize the EAT “as an agent for state tax transfer purposes will not affect the qualification of a transaction under Section 1031.” Care should be taken to research whether a transfer tax is imposed when transferring title from the EAT to the Exchangor.
Is a deferred improvement exchange applicable to the transaction you are considering? If so, contact our office by either calling or clicking on the button below to ask your question or for a complimentary consultation with our Certified Exchange Specialist©.
