An improvement exchange, also known as a “build-to-suit” or “construction” exchange, is a variation of a 1031 exchange that allows real estate investors to use the proceeds from the sale of a relinquished property to fund improvements or construction on a replacement property.
In a standard 1031 exchange, investors must identify and acquire a replacement property of equal or greater value within specific timeframes to defer capital gains taxes. However, in an improvement exchange, investors have the option to acquire a replacement property that requires improvements or construction to meet their investment objectives.
Here’s how an improvement exchange typically works:
- Sale of Relinquished Property: The investor sells their relinquished property and proceeds are held by a qualified intermediary (QI) to facilitate the exchange.
- Identification of Replacement Property: Within the identification period (usually 45 days), the investor identifies the replacement property that will undergo improvements or construction.
- Construction or Improvement Plan: The investor works with contractors, architects, or other professionals to develop a plan for the improvements or construction on the replacement property. The plan should be completed and documented before the exchange proceeds.
- Exchange Agreement: The investor enters into an exchange agreement with the QI, specifying the intent to undertake an improvement exchange and the details of the construction or improvement plan.
- Acquisition of Replacement Property: The investor acquires the replacement property and holds it while the improvements or construction are carried out. The construction or improvement period is usually within the 180-day exchange period.
- Completion of Improvements: The improvements or construction on the replacement property are completed as outlined in the construction or improvement plan. It is essential to adhere to the plan to ensure compliance with the exchange rules.
- Tax-Deferred Status: Upon completion of the improvements or construction, the replacement property is deemed to have met the like-kind requirements of a 1031 exchange. As a result, the investor can defer the capital gains taxes on the sale of the relinquished property.
It’s important to note that the improvements or construction must be significant and not merely cosmetic changes. The investor should consult with tax professionals and follow the guidelines set by the IRS to ensure compliance with the rules of an improvement exchange.
An improvement exchange provides investors with the opportunity to acquire a replacement property that better aligns with their investment goals and potentially increases its value through improvements or construction. By deferring capital gains taxes, investors can allocate more funds towards enhancing the replacement property and potentially generating higher returns on their real estate investments.