A 1031 improvement exchange is utilized when a taxpayer would like to make improvements to the replacement property as part of their 1031 exchange. Improvement exchanges are also referred to as build to suit exchanges or construction exchanges. An example of a 1031 improvement exchange would be the sale of commercial property and then replacing it with another commercial building that the net sales proceeds of their 1031 exchange were used to improve.
The Basics of an Improvement Exchange
An improvement exchange implies that the replacement property is acquired prior or after the old property is closed. Improvements to the new property are made with title conveyed to the taxpayer either on or before the 180th calendar day post initial closing. As long as the value of the improvements plus the cost of the replacement property is equal to or greater than the old property, the construction exchange allows taxpayers to defer the capital gains tax and recaptured depreciation triggered when the old or relinquished property was closed.
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. This is a key consideration when considering an improvement exchange, can your general contractor complete the full amount of improvements to defer the entirety of your capital gains tax and depreciation recapture. As stated before, the material and labors must be affixed to the ground in order for the usage of the exchange funds to be validated.
Improvement Exchanges and Revenue Procedure 2000-37
Created by the IRS, Revenue Procedure 2000-37 provides a safe harbor for “parking” exchanges where Taxpayers “park” their old or new properties with a non-related party known as an “Exchange Accommodator Titleholder” (EAT) for up to 180 calendar days. In a 1031 improvement exchange, the safe harbor allows the EAT to construct the improvements on the replacement property and transfer title or ownership in the EAT to the Taxpayer to complete the 1031 exchange.
In a recently completed $8 million 1031 improvement exchange of commercial property, the replacement property was acquired in the name of the EAT. Funding was provided for the EAT to pay the construction vendors. The old property was sold and title to the new property with the improvements was transferred to the Taxpayer. The 1031 improvement exchange was completed within 180 calendar days post replacement property purchase. Construction can continue after the 180th calendar day though those improvements do not defer gain given the 1031 exchange has been completed.
The taxpayer can make cash or credit card payments directly to the contractors or vendors and reimbursed by the EAT. This provides the taxpayer flexibility to work with contractors who require real time payments.
Transfer Fees or Stamp Taxes and Improvement Exchanges
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.
Next Steps
Are you considering selling a property held in a business or as an investment and want to make improvements to the replacement property? Do you have questions about financing or transfer of title? Who is the EAT and how are your protected? Reach out to us via our consultation form here or call our office any time at 800-227-1031. We look forward to hearing from you and assisting you with your improvement exchange.
