1031 Improvement Exchange Rules for Replacement Property

Key Takeaways

• A 1031 improvement exchange lets a taxpayer use exchange proceeds to repair, renovate, or construct improvements to a replacement property before taking title.
• Taxpayers must identify the planned improvements within 45 days of selling the relinquished property.
• Improvements do not have to be complete when the taxpayer takes receipt of the replacement property or when the 180-day exchange period ends, whichever comes first.
• Only the value of improvements completed by the time the taxpayer takes receipt counts toward the exchange; improvements made after the taxpayer takes title are not like-kind property.
• A seller, developer, qualified intermediary (QI), or Exchange Accommodation Titleholder (EAT) can complete the improvements on the taxpayer's behalf.
• Improvement exchanges can help taxpayers pursue value-add properties, offset a lower-value replacement property, or complete a built-to-suit purchase.

What Is a 1031 Improvement Exchange?

IRC Sec. 1031 lets a taxpayer defer gain or loss on the exchange of real property held for productive use in a trade or business, or for investment, for like-kind real property held for the same purpose. “Like-kind” was broadly defined before the Tax Cuts and Jobs Act (TCJA), but the TCJA narrowed the definition in 2017 to include only real property.

Often, taxpayers will want to make improvements to replacement property and have the cost of such improvements included in the exchange value of the replacement property in a deferred exchange. Such improvements may be in the form of repairs, renovation of the property to be acquired, or even the construction of a new building on vacant land. Generally, improvements acquired after the taxpayer has acquired the replacement property do not qualify as like-kind replacement property.

Who Can Complete the Improvements?

A seller, a developer, a qualified intermediary (QI), or an Exchange Accommodation Titleholder (EAT) can make the improvements on the taxpayer's behalf.

What Are the Improvement Exchange Deadlines?

Taxpayers must identify the improvements within 45 days of the exchange period. The improvements do not have to be complete when the taxpayer takes receipt of the replacement property or when the 180-day exchange period ends, whichever comes first.

How Much of the Improvement Value Counts Toward the Exchange?

The exchange includes only the value incurred at the time of receipt in determining the deferred gain. For example, if 40% of the intended renovation is complete by the time the taxpayer takes receipt, only the actual cost incurred up to that point is eligible for inclusion in the exchange.

Careful planning is necessary when doing improvement exchanges so that the exchange falls within the strict rules of IRC Sec. 1031 and achieves maximum deferral for the taxpayer.

When Does an Improvement Exchange Make Sense?

An improvement exchange can be a valuable planning tool for taxpayers pursuing value-add properties, offsetting a lower-value replacement property, or completing a built-to-suit exchange.

EisnerAmper's Real Estate Services Group guides taxpayers through complex 1031 improvement exchanges. Contact EisnerAmper to discuss your 1031 exchange strategy.