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1031 Improvement Exchanges: Tax-Efficient Property Upgrades

Did you know that you can use a 1031 exchange as a strategic way to enhance property value with improvements, while deferring taxes? It’s called a 1031 improvement exchange, and lets you use some of the proceeds from the sale of a relinquished property to make rehabilitations and renovations to a replacement property. This guide will help you know how to allocate exchange funds effectively in a way that not only improves the property, but also lets you defer capital gains tax. 
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What is a 1031 Improvement Exchange?

Traditional 1031 exchanges let you sell a property that you own for business use or investment purposes, and use the proceeds from the sale to buy a like-kind property without paying capital gains taxes. Reverse 1031 exchanges reverse the process: they are for when you buy a replacement property before you have closed on the sale of your relinquished property. 

 

A 1031 improvement exchange adds another layer, letting you use funds from the sale of your relinquished property for improvements on a like-kind property. If the value of the replacement property is less than the one you sell, improvements can be used to increase the value enough to meet the requirements for full deferral of capital gains taxes. Improvement exchanges can be either traditional or reverse exchanges.

Benefits of Improvement Exchanges

One tremendous benefit of an 1031 improvement exchange is that it lets you use pre-tax dollars to increase the property value of your new, replacement property through enhancements to existing structures. This allows for significant property appreciation. The proceeds from the sale of your relinquished property that are used toward the acquisition and improvement of your replacement property, as well as those proceeds that are paid or used for the improvements, will qualify for tax deferred exchange treatment provided the transaction is properly structured as a 1031 improvement exchange.

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Detailed Process for a 1031 Improvement Exchange

1

Contact 1031 Pros for advice on structuring your 1031 improvement exchange.

2

Because Section 1031 does not allow you to own both properties at the same time, you will sell the relinquished property through a qualified intermediary and Exchange Accommodation Titleholder (or EAT), or in some cases acquire the replacement property first through a parking agreement.  

3

As your qualified intermediary, we will set up a special purpose entity, often a single member limited liability company, that is used to acquire and park the title to your replacement property during the exchange. 

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We will work with you to use exchange funds to improve the replacement property. 

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At the end of the exchange, the replacement property and any construction loans will often be transferred to you through the holding entity, rather than by a deed. We will work with you to ensure compliance with all tax and other legal issues. 

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Regulatory Guidelines and Compliance

All of the proceeds from the sale of your relinquished property must be used to acquire and improve the replacement property, in order to qualify for tax deferral. Also, you must adhere to a strict timeline: there is a 45 day timeline for identifying a replacement property and a 180 day timeline for completing the exchange. If you miss these deadlines, you are responsible for paying capital gains taxes on the sale of your relinquished property. At 1031 Pros, we will help you navigate the complexities of exchanges successfully. 

Project Planning and Execution

As with all construction and renovation projects, there can be costly delays. It is important to plan for these and work closely with your contractors and vendors in order to make sure that the 180 day deadline is met. This means reviewing plans, specs, and project documents, going over every detail of the scope of work. 

It is also helpful to create and coordinate a master schedule with all parties and refer to it often, modifying it as needed, and implementing contingency plans that you have put in place. From there, communication and collaboration are key! You want to get regular updates on progress, monitored and documented, to ensure that you meet the deadline. 

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Financial Considerations and Risk Management

Improvement 1031 exchanges can be more complicated and costly than traditional 1031 exchanges, so be aware of the amount of depreciation recapture and capital gains tax liabilities that are being deferred, to ensure that the cost of the improvement exchange is worthwhile. 

 

To fully defer capital gains taxes, all of the exchange equity must be invested in products and services on the new property; any unused funds are taxable. Exchange funds that have been placed in escrow for post-closing improvements do not qualify, even if the funds are deposited before you take the title.

If the exchange funds do not cover the acquisition and improvement of the new property, additional funds can be loaned to 1031 Pros as your qualified intermediary and Exchange Accommodation Titleholder (EAT). If you need a construction loan from an institutional lender, you should seek lender approval prior to starting the exchange. You can also partner with your developer, using a construction reserve in the exchange account. 

Acting as project manager for the construction, you will send invoices to 1031 Pros, as your EAT, to be paid directly to your vendors. During the exchange period, you cannot be reimbursed for any advances or expenses incurred. As you are allocating a budget for the construction project, always be aware of potential cost overruns! 

At every step of the way, 1031 Pros is here to help. 

Choosing Properties Suitable for Improvement Exchanges

Before entering any real estate transaction, you will want to look at the economic stability of the area where your replacement property is located, as well as gauge local demand for the type of your improvement project. Finding a property in a high-growth area is ideal, as well as one that allows significant value-add through the improvements, or even one that is under market value with high upside potential. It’s important to understand market trends and future growth potential, and we’ll work with you to help make sure that you select the right replacement property. 

Call Us for a Free Consultation

Our customer service is unmatched in the industry, including a live person answering the phone when you call at any time, 24/7, and responses to emailed questions within 24 hours. Contact us at 916-252-6900 for a free consultation before starting your 1031 improvement exchange, or even to discuss long-term strategies for your portfolio, to ensure that you are set up for success.

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  • What type of property qualifies for a 1031 exchange?
    Any property held for productive use in a trade or business or for investment can be exchange for like-kind property. "Like-kind" refers to the nature of the investment. Any type of real property can be exchanged for another type of real property. For example: A single family rental can be exchanged for a duplex. Raw land can be exchanged for a shopping center or an office space for apartments. Any combination will work. This gives the investor flexibility to change investment strategies to fulfill their portfolio needs.
  • What Does Not Qualify?
    A personal residence, developed lots, home flipping, partnership interests or property held for resale immediately after acquisition. Second homes may or may not qualify depending upon the use and how it's reported for income tax purposes.
  • What kind of exchanges does 1031 pros handle?
    We handle all types of exchanges: Delayed Exchanges, Reverse Exchanges and Build to Suit Exchanges. From the simple to the complex, we can handle any type of exchange.
  • Does 1031 Pros handle exchanges in any state?
    Yes. We can handle exchanges for any property in any of the 50 states.
  • How much notice do I need to do a 1031 Exchange?
    You can do a 1031 exchange any time before closing on the sale of your investment property. Like we said before, we're fast.
  • How long do I need to own my investment property before I can exchange it for another?
    There is no set timeline, but to avoid any issues you should at least own it for a minimum of 12 months.
  • What happens if I don't close on my replacement property within 180 days?
    Then you just pay the capital gain taxes like your would have if you were to sell the property in the first place.
  • Can I sell one property and exchange into multiple properties?
    Yes, in most cases you can exchange into three other properties.
  • Why should I use a qualified 1031 intermediary to do my exchange?
    We will prepare all the correct paperwork you will need to file your taxes with. We will also ensure you meet your timelines and any other specifics of the 1031 tax code.
  • What if my Title company is a qualified 1031 intermediary?
    1031 Pros specializes in exchanges and has the expertise, experience and history to ensure an audit free exchange.
  • What is a reverse exchange?
    A reverse exchange is when you close on the purchase of the replacement property before you close on the sale of the relinquished property. Many real estate investors will utilize a reverse exchange to acquire a replacement property in a market where there may be competing offers or there is a need to close fast. Because of our vast experience handling these types of exchanges, we offer very competitive rates and are willing to match any competitor pricing.
  • What is an improvement exchange?
    Also referred to as a construction exchange or build-to-suit exchange, improvement exchanges offer real estate investors nice benefits, which often result in better investment opportunities than properties readily available on the market. The ability to remodel, add capital improvements, or build from the ground up, while using tax-deferred dollars, allows an investor to reinvest in a replacement property that meets their exact investment criteria.
  • What is the Federation of Exchange Accommodators?
    The Federation of Exchange Accommodators (FEA) is the only national trade association organized to represent professionals who conduct like-kind exchanges under Internal Revenue Code §1031. Members include Qualified Intermediaries (QIs), their primary tax and legal counsel, and affiliated industries (TIC sponsors, banks, real estate brokers, title companies, settlement/escrow agents, etc.). 1031 Pros is a proud member of the FEA.
  • Can I 1031 exchange into a Tenancy in Common or Triple Net Lease Property?
    Yes, you can exchange into a Tenant In Common (TIC) or Triple Net Lease real estate investments. The biggest rule of thumb is that your name is on the title as an owner with a percentage of ownership. These types of real estate investments offer a great passive income for those who are done with being a landlord and are ready to sit back and collect a monthly check. We do not offer these types of investments at 1031 Pros, but we have some great partners who do. Call us today to learn more.
  • Does my personal residence qualify for a 1031 exchange?
    No, it does not. Personal residences qualify for different tax benefits under IRS Code Section 121. Section 121 allows a taxpayer to exclude up to $250,000 ($500,000 for certain taxpayers who file a joint return) of the gain from the sale (or exchange) of property owned and used as a principal residence for at least two of the five years before the sale. 1031 Pros does not offer any services or tax advice for personal residences. Please contact our trusted Accounting partners under the "More Tab" for more information on Section 121. Tell them 1031 Pros sent you!
  • Are my funds insured?
    Each of our exchanges uses a unique, individual, FDIC insured account. 1031 Pros also has additional bonding and insurance, so your funds are always safe and secure.

Have More Questions? Send Us a Message.

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