1031 Secrets The IRS Doesn't Want You To Know

Tuesday, February 23, 2016 by Michael Brady


Investors commonly use 1031 exchanges to defer capital gain taxes by exchanging their property for other like-kind property. However, few investors realize that their sales proceeds can also be used to pay for construction costs and to make capital improvements to a replacement property.

This type of 1031 exchange is often referred to as an “improvement” or a “build to suit” exchange. Title to the replacement property is “parked” with an “Exchange Accommodation Titleholder” or “EAT”, which is usually a limited liability company that is solely owned by the qualified intermediary facilitating the exchange.

At the time of the acquisition, the EAT can enter into a construction agreement with the investor. They can then make improvements to the property during the balance of their exchange period, using a portion of the sales proceeds from the relinquished property to pay for the construction. Once the work is completed or the exchange period is about to expire, the EAT will transfer the property to the investor at its improved value.

For example, if an investor sells a property for $1 million, they will need to acquire a replacement property worth at least $1 million to fully defer their capital gain taxes. Suppose they find an ideal property that is worth only $700,000, but the property needs renovations, like replacing the roof and windows, and repaving the parking lot?

In a properly structured improvement exchange, the EAT will acquire title from the seller of the property, using a portion of the sales proceeds to pay the purchase price. Then, during the balance of the exchange period, the EAT will use the remaining sales proceeds to make those renovations. If the capital improvements cost at least $300,000, the investor will fully defer the taxes on their capital gain.

Unfortunately, the exchange period is a maximum of 180 days, so there is not much time to complete the necessary work. Therefore, an improvement exchange is usually easier to accomplish with the rehabilitation of an existing structure, compared to building a new structure on vacant land. Additionally, the exchange funds cannot be used to make improvements to a property that is already owned by the investor. Nor is it sufficient to just purchase supplies during the exchange period; the work must actually be completed, and the progress of the construction should be documented. It is also critical that both the replacement property and the planned improvements be identified during the 45 day identification period. Finally, the work performed must be considered capital improvements, as opposed to routine maintenance and repairs.

As improvement exchanges are more complex than the typical 1031 exchange, advanced planning is essential.  The taxpayer’s attorney and accountant must both be involved in structuring the transaction, and a knowledgeable qualified intermediary should be contacted early in the process. 

As many investors are facing tax rate increases, the improvement exchange has become an even more valuable tool, allowing them to both save taxes and modify their replacement property to better suit their investment objectives.

Michael S. Brady, Esq. is Counsel for Riverside 1031 LLC, a national Qualified Intermediary for 1031 Exchanges.  He has earned Certified Exchange Specialist® designation from the Federation of Exchange Accommodators, the national trade association organized to represent professionals who conduct like-kind exchanges under Internal Revenue Code §1031. Mr. Brady has been involved in real estate and tax matters for over 20 years.

Shaul Greenwald and Yoel Zagelbaum, co-founders of Riverside 1031, have been practicing real estate law since 2007. They are also the founders of Riverside Abstract, our sister company which has attracted a wide client base of successful investors thanks to its multi-disciplinary, multi-state, nationwide experience and top-notch team of professionals who consistently pull off the kind of complex real estate transactions that have earned us the respect of America’s top real estate law firms.