A 1031 improvement exchange is one of many types of 1031 exchanges that follow the same strict rules defined in Internal Revenue Code Section 1031. A 1031 exchange enables the Taxpayer to defer federal and state capital gain and depreciation recapture taxes when selling and replacing real and personal property held in the productive use of a business or for investment. Real property can only be replaced with real property while personal property must be exchanged for like-kind or like-class personal property. Property predominantly located in the US is only exchangeable for property held predominantly in the US. Foreign real and personal property are eligible for the tax deferral if exchanged for real and personal property held predominantly outside the US.
Improvement Exchange Mechanics
Improvement exchanges are initiated when either the replacement property is acquired and then improved with exchange proceeds, followed by the relinquished or old property sale or when the relinquished property is sold, followed by the replacement property purchase and improvement with exchange proceeds. In either sequence, the property to be improved must be parked with an Exchange Accommodator Titleholder or EAT. The EAT is typically a single member limited liability company (SMLLC) created by the Qualified Intermediary for the sole purpose of taking title or parking the property to be improved. Be careful that the EAT does not comingle properties in the EAT. If a lien was to be adjudicated on the EAT, the properties would be frozen until a resolution. The Taxpayer has a secured position in the SMLLC along with a lease, promissory note and other associated exchange agreements. Either the Taxpayer or the Qualified Intermediary pays the Taxpayer approved contractor invoices. At the end of the exchange, as determined when the relinquished net equity and debt retired is fully expended towards the purchase and improvements, the property is conveyed to the Taxpayer, completing the 1031 exchange.
Title conveyance can either be accomplished by assigning the membership interest in the SMLLC to the taxpayer or by recording a warranty deed. In some states, recording a warranty deed triggers a transfer tax, first on the transfer to the EAT and second to the Taxpayer. States such as Florida recognize the role of the EAT and do not assess a double documentary stamp tax. To avoid the transfer tax, the membership interest can be assigned. Awareness of local tax laws is important.
Minor improvements often do not warrant an improvement exchange. Expenditures of $20,000 or less may not support the Qualified Intermediary expense. Soft costs, such as architectural, permits, attorney and CPA fees incurred and paid months in advance of the EAT’s parking the replacement property, can be reimbursed to the Taxpayer.
1031 Exchange Rules
The 1031 exchange rules that apply to all improvement exchanges including the following partial list:
- The 1031 exchange must be completed within 180 calendar days of the initial closing
- Replacement and relinquished properties in a reverse 1031 exchange must be identified, preferably to the Qualified Intermediary by the 45th calendar day post-closing
- Qualified Intermediary may not be a disqualified person
- Related party rules apply to party buying the relinquished and the party selling the replacement property
- The Taxpayer who sells is the taxpayer who buys
- Debt and equity must be equal to or greater in the replacement property or a tax is triggered on the difference
- Exchange funds must be held in a manner that prohibits access by the Taxpayer, preserving principal and liquidity
We Can Help
Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.
Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.
