Room for Improvement
By Bob Hartwick

Property Owners often wonder if they can build or make improvements to their replacement property during a Tax-Deferred (1031) Exchange. Fortunately, the tax code provides investors with this flexibility. An improvement exchange (also known as a construction exchange) allows investors to build or improve properties to suit their needs.

If an exchanger disposes of property at one value and replaces it with a property of lesser value, there could be a tax liability on the difference. The investor can reduce or eliminate this liability by increasing the value of the replacement property through improvements. In this format, the Intermediary retains ownership to the replacement property and makes improvements to it. Once the improvements have been made, ownership is passed to the exchanger and the transaction is complete. The improvement exchange provides a great opportunity to balance an exchange and avoid tax liability.

Under most circumstances improvement exchanges can only be accomplished if cash is available to pay for the replacement property and the improvements, or if the seller is willing to carry the financing. If conventional financing is needed to purchase the land or to pay for the improvements, the likelihood of being able to do an improvement exchange is slim. Most lenders will not lend to an investor when an Intermediary is holding title to the property pledged as collateral for the loan. It is possible for the Intermediary to sign a subordination agreement or even execute the loan documents, but potential liability typically deters Intermediaries from doing so and most lenders are not willing to accept an Intermediary as the payor on the loan.

The following is an example of an improvement exchange when the exchanger is working with all cash. First, the Exchanger transfers an office building to the Intermediary valued at $250,000 with no debt. The Intermediary sells the property and uses $50,000 of the cash to purchase a piece of bare land. Once the Intermediary has acquired the land, the Exchanger makes arrangements with a contractor to build a new office structure valued at $200,000. The Intermediary will remain on the title and pay the contractor until all exchange proceeds have been used. Once the improvements have been made, the Intermediary transfers to the investor property valued at $50,000, plus improvements valued at $200,000 for a total exchange valued at $250,000.

The standard delayed exchange time requirements still pertain to the improvement exchange. Investors must identify the real property to be acquired as well as the improvements to be made within 45 days of closing of the relinquished property. These improvements should be described in as much detail as possible. The improvements must be made and the property transferred to the investor within 180 days of closing the relinquished property.

Although not all of the improvements have to be completed in 180 days, enough work needs to be complete to increase the value of the replacement property to a level equal to the relinquished property. The regulations also state the finished project must be substantially the same as what was identified. In other words, one could not identify a 50-unit apartment complex to be constructed and end up with a three-story office complex.

Careful consideration of timing should be at the forefront when planning an improvement exchange. While the improvements themselves can often be made within 180 days, external factors can influence the pace of the improvements. Issues such as weather conditions, difficulty-obtaining building permits and delays in construction can wreak havoc with the timing of the improvement's completion. These external conditions should always be considered and the investor should take into consideration steps needed to minimize any potential problems.

Many investors wrongly believe they can make the needed improvements to their replacement property after closing and they have received title to the property. This alternative is not valid for improvements; once the purchase closes, any cash not used is "taxable boot" to the investor. If the investor has constructive receipt of the funds, there is a tax liability on the amount received.

Some investors also wrongly believe if they leave "left over" funds in the control of another party (such as the seller, Intermediary of title company), with an agreement the other party will make the needed improvements, they can escape paying taxes on the "boot". This does not satisfy the IRS because along with receiving real property in an exchange, the investor is also receiving a contractual obligation. A contract is personal property and not like kind to real property; as a result, the value of the obligation is taxable.

The improvement exchange affords investors great opportunities to acquire desirable replacement properties. If the obstacles of financing, identification and timing can be overcome, an exchanger can end up with an ideal property suited to specific needs.

This is the second in a series of four articles to be published on Tax Deferred Exchanges. Bob Hartwick is an associate Broker with RE/MAX of Petoskey and has been involved with resort property sales for over ten years. This material is provided for informational purposes only and is not to be construed as tax advice. The reader is strongly advised to speak with a tax consultant before attempting to employ any of the concepts stated herein.

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Free Tax-Deferred Exchange Information
Did you know that there is a reverse 1031 Exchange, where an investor acquires the replacement property before closing on the relinquished property? Did you know that an investor could trade out of one property into several, or consolidate from smaller properties into one larger property?

Most people don't take advantage of a Tax-Deferred Exchange because they believe it is too difficult or they obtained incorrect information.