What if there was a way to make your real estate investment do double duty: acquire a new property and remodel it, increasing its value while avoiding immediate capital gains tax? You might be excited to learn that this is the true power of an Improvement 1031 Exchange. Delve deep into what an Improvement 1031 Exchange is, its advantages, drawbacks, and why it may or may not be the right choice for you.
What is a 1031 Exchange?
Before we discuss the Improvement 1031 Exchange, let’s understand the basics. Section 1031 of the Internal Revenue Code allows for what is known as a 1031 Exchange. It enables you to defer the capital gains tax you normally incur when selling an investment property, provided you reinvest the proceeds into another “like-kind” property. This type of transaction has long been a valuable strategy for savvy real estate investors.
What is an Improvement (Build-to-Suit) 1031 Exchange?
When it comes to understanding a 1031 exchange, it’s important to note that this exchange lets you not only exchange one property for another, but you can also make improvements to the replacement property. This feature sets it apart from a traditional 1031 exchange. You can customize the new property to fit your needs and your tenants. You’re still held to a timeline—there is a 45-day identification period and 180 days to complete the exchange, but the advantages can be significant. Property developers and investors who cannot acquire a perfect “like-kind” replacement property often find this exchange beneficial. They can sell the old property and use the proceeds to improve a new one they may not have otherwise considered.
How Does a Build-To-Suit 1031 Exchange Generally Work?
You first need to sell your existing property. The proceeds from this sale go into a qualified escrow account managed by a Qualified Intermediary (QI). The investor must identify the replacement property and any improvements they’ll make within 45 days of selling the existing property. A QI uses the funds in the escrow account to purchase the replacement property. The property is often initially deeded to an Exchange Accommodation Titleholder (EAT) or a similar legal structure for holding during the improvement phase.
Funds from the escrow account are used to construct improvements on the replacement property. Builders must complete the renovation within 180 days of the sale of the relinquished property. After the upgrades, the property is transferred from the EAT to the investor to finalize the 1031 Exchange.
Best Uses for an Improvement 1031 Exchange
Some situations make this an ideal exchange solution:
- Upgrading Outdated Properties
If you own an outdated property, the Improvement 1031 Exchange allows you to invest in a new property that you can customize with the proceeds from the sale of the original property.
- Lack of a Perfect “Like-Kind” Property
In some markets, finding a direct replacement property can be difficult. This delay allows you to look for a property that could meet your needs with improvements and adapt it rather than trying to find something perfect–an excellent option in tight real estate markets.
- Portfolio Diversification
By exchanging a property such as an apartment building for a single-family home, for example, you can diversify your holdings and risk by acquiring different types of property for your portfolio.
The Risks and Why You Might Avoid a Build-to-Suit Exchange
This type of exchange isn’t for everyone due to its complexity. It requires meticulous planning and a strict adherence to IRS rules. The tight timelines can cause stress for investors waiting for construction to finish within the 180-day days. The financial risks can also be significant, with high upfront costs and potential overruns on improvement budgets. We strongly recommend involving skilled professionals like contractors, lawyers, and Qualified Intermediaries to guide you.
Other Types of 1031 Exchanges
- Deferred or Delayed Exchange
This exchange is the most common, where you sell your old property before acquiring a new one.
- Simultaneous Exchange
The sale and the purchase occur simultaneously.
- Reverse 1031 Exchange
You acquire the replacement property before selling your old property.
Improvement 1031 Exchanges offer a unique opportunity for investors to customize their new properties while deferring capital gains tax. However, the process is complex, with inherent financial and deadline-related risks. It’s crucial to weigh these considerations carefully.
Half a Century of Expertise
With over 50 years of experience, Cortes & Hay brings a seasoned depth of knowledge and a suite of tools specifically designed for effectively managing complex transactions. Whether you’re a first-time investor or a seasoned developer, our expertise can guide you through the labyrinth of IRS rules, ensuring a smooth and successful exchange.
Don’t navigate the intricate world of 1031 Exchanges alone. Leverage the experience that Cortes & Hay brings to the table. Contact us today for a consultation to find the 1031 exchange strategy that best suits your investment needs.