Through improvement exchange, investors can explore multiple improvement options for the properties currently in use. An investor can modify an existing property to achieve what they need. Some improvements are more straightforward, and others are complex. Either way, investors get to enjoy tax deferral and maximize investment opportunities throughout the improvement process.
Table Of Contents
- 1 WHAT IS AN IMPROVEMENT EXCHANGE 1031?
- 2 WHAT IS A BUILD-TO-SUIT EXCHANGE?
- 3 IMPROVEMENT EXCHANGE REQUIREMENTS
- 4 LET’S EXPLORE THE 1031 IMPROVEMENT EXCHANGES PROCESS
- 5 BENEFITS OF THE 1031 IMPROVEMENT EXCHANGE
- 6 REVERSE IMPROVEMENT EXCHANGE
- 7 WHEN TO USE 1031 IMPROVEMENT EXCHANGE
- 8 FLEXIBLE PROVISIONS IN THE REVENUE PROCEDURE 2000-37
WHAT IS AN IMPROVEMENT EXCHANGE 1031?
A 1031 exchange is a tool that investors can use within the Improvement Exchange to create tremendous investment opportunities and avoid paying capital gains taxes on the proceeds from the sale of the improved replacement property. However, full tax deferral is only possible when the investors acquire replacement property with a market value that is more than or the same as the property on sale. They must also invest the proceeds from the existing property in a new investment property.
WHAT IS A BUILD-TO-SUIT EXCHANGE?
With a build-to-suit exchange, the owner of relinquished property can use the sale earnings to get a replacement property and make the necessary improvements. That makes it easier for exchangers to capitalize on the investment opportunity by using 1031 exchange proceeds to construct or renovate the new property. If there is no other action, the surplus-value lost is tax-deductible in the context of an IRR.
Difference between a build-to-suit exchange and 1031 improvement exchange
Build-to-suit exchange applies when the new investment property is a piece of land for construction. On the other hand, 1031 improvement exchange is when there are existing structures that require refurbishing. Safe harbor provisions are available to ensure adherence to the procedures.
IMPROVEMENT EXCHANGE REQUIREMENTS
Below are the basic requirements for an exchanger to enjoy tax-deferred dollars when using the exchange.
The 1031 exchange requirements apply to the improvement exchange. The exchanger must use the exchange equity to complete improvements or make a down payment within 180 days. The improvement process must be complete before the exchanger can acquire the title of the new property. Meeting the like-kind requirement mandatory in improvement exchanges can be challenging within the 180-day exchange period. The exchanger receives real property when they give up one. That means if they receive unimproved property, full tax deferral will not be possible, even if the materials and labor force for improving the property are available. Those elements are in the services and personal property categories, meaning they are not like-kind to real property. An expandable company can finance the 1031 exchange if it receives non-improved land for future use.
The exchanger must identify replacement property within 45 days after the sale of the other one. That means disposing of the relinquished property, sending the earnings to a qualified intermediary, and coming up with a description of the new construction within that timeline.
The value of the replacement property must be greater or equal to the relinquished property with the completed improvements. That is known as the exchange value requirement or Napkin Test.
Do all improvements need to be made during the 180-day parking period?
If completing the improvements is not possible within the 180-day exchange period, the taxpayer gets credits for the value of land and improvements installed at the time of direct ownership. It will be up to the taxpayers to improve their services once this has happened.
LET’S EXPLORE THE 1031 IMPROVEMENT EXCHANGES PROCESS
Taxpayers gain more from an old property than a new one – the original purchase price is often lower than the final value of the replacement properties. That means the relinquished property value is usually higher than the replacement property value. If other factors do not interfere, the investors can reinvest the difference in property value and incur tax deductions under the 1031 exchange Internal Revenue Code. Improvements on the new property mean the exchanger can clear improvement costs before the completion process. They can use the built-to-suit exchange or property improvement exchange. That means developing a brand-new property on a piece of land or renovating an existing structure.
Investors must use a qualified intermediary (QI) in the improvement exchange format because the title to the replacement property must be in a third party’s name. The third party can also be an exchange accommodation titleholder (EAT) whose name appears on the purchase contract with as much detail as possible. In some cases, exchangers use contractors to get land for new construction.
Only the title to the replacement can go to the EAT or QI. The exchange funds go to an exchange account that the taxpayer or exchanger creates. The exchange accommodation titleholder will pay for the improvement expenses from the escrow account with the guidance of the investor.
The qualified exchange accommodates agreement allows the representative to hold the title for the 180-day exchange period or until the completion of the new construction. Improvement exchanges requirements for new property constructions tend to be more stringent. For instance, once QI or EAT takes title, they can only give it back when construction is complete within 180 days. The entire exchange equity must also go towards the building costs within the stipulated duration.
Sometimes the taxpayer takes a construction loan to finish the improvements. The purchase agreement allows the representative to remain responsible for the loan funds until the transfer of replacement property to the taxpayer.
BENEFITS OF THE 1031 IMPROVEMENT EXCHANGE
An exchanger can renovate, construct from the ground up, and add capital improvements while enjoying tax deferral, making it a better investment.
The 1031 exchange offers several advantages which can lead to tremendous investment opportunities, such as more valuable properties than properties readily available on the open market.
In addition, the ability to remodel and improve the infrastructure can help provide tax-deferred investments that are more lucrative. Other options are available under the new version of these regulations, and since 1993, Treasury Regulations and the Rev. Proc. 2000 – 35 established the standards of improving the production of the product. Improvement exchanges continue.
One of the other advantages of a new property is that the same property must not require complete replacement within 180 days.
The biggest drawback of the improvement exchange
Building from the ground up within the 180-day exchange period is not easy. Build to suit exchange costs can also be higher than other tax-deferred exchanges. Transfer taxes, closing charges, and escrow fees add to the total exchange funds.
REVERSE IMPROVEMENT EXCHANGE
Improvement exchange can be delayed improvement exchange or reverse improvement exchange. Delayed improvement is the most popular. It involves the disposition of the relinquished property and sending the 1031 exchange proceeds to the QI.
Reverse exchange is an improvement exchange format where the EAT acquires the replacement property after getting funds from the taxpayer or lender.
Difference between forward and reverse build-to-suit or improvement exchanges
Building/improvement swapping is a twofold process. A taxpayer can sell the property before the purchase date and fund a new 1031 exchange account. The exchange funds can go to the EAT in exchange for a share in new investment. The remaining amount of money becomes available to EAT as needed to pay for costs related to the work. That is forward construction/sales exchange.
Reverse build-to-suit applies when the exchanger wants to add capital improvement before completing the sale of the original property.
WHEN TO USE 1031 IMPROVEMENT EXCHANGE
1031 improvement exchange is commonly utilized when the replacement property does not have equal or greater value to the relinquished property. The 1031 exchange removes the taxable situation by adding capital improvements.
1031 also applies when an exchanger does not want properties in the open market or if a taxpayer prefers to use tax-deferred dollars to refurbish a new investment property with equal or greater value.
FLEXIBLE PROVISIONS IN THE REVENUE PROCEDURE 2000-37
The revenue procedure provides the following:
· The exchanger can be the contractor during the improvements
· EAT can lease the acquisition to the taxpayer within the parking period
· The exchanger can guarantee construction loans that EAT gets or loan them directly
· A taxpayer can compensate EAT for expenses
How does the use of an EAT help in an exchange involving improvements?
EAT can retain ownership of the title and park the new property for the taxpayer while the improvement exchanges continue for 180 days. After ownership transfer, the taxpayer gets the improved property with the additional value achieved during parking. EAT uses a limited liability company to isolate exchange transactions.