By Darden Bell, CPA | Tax Manager | Real Estate & Construction Industry Team
Many real estate investors know that IRC Section 1031 Exchanges are a great way to dispose of property and acquire new property on a tax deferred basis.
In order to accomplish full tax deferral on the gain generated by the sale of property, 100% of the sales proceeds must be reinvested in new property that is to be held either for productive use in a trade or business or for investment. Any sales proceeds not reinvested will be treated as taxable “boot” once the 180-day exchange period closes.
Many times, a taxpayer is unable to identify a desirable property to acquire that costs as much, or more, than the total sales proceeds they need to reinvest. However, they may be able to identify a property they would like to acquire and renovate, but the current sales price is less than the amount of proceeds they need to reinvest.
Luckily for taxpayers, the IRS allows you to enter into a property improvement exchange. It is important to note that the taxpayer cannot acquire the property themselves and then use exchange proceeds to renovate the property after acquisition. Hiring a contractor and paying for labor and materials does not qualify as “like-kind” to the sale of real estate.
What is a property improvement exchange?
A property improvement exchange is an arrangement where an Exchange Accommodation Titleholder (EAT) holds title to the property while the improvements are being made. In order for the cost of improvements to count towards the use of sale exchange proceeds reinvested, the improvements must be made before the taxpayer legally takes title to the property. In Lehman’s terms, the EAT acquires the property in their name and oversees the entire improvement process while holding title. This process is referred to as “parking” the property. Once the improvements are completed, the EAT transfers ownership of the property to the taxpayer. The end result of this process is the taxpayer acquiring the property that includes the value of the improvements that were made during the parking period. This can been done with either a forward or reverse improvement exchange.
A forward improvement exchange occurs when a taxpayer sells a property first and funds the exchange account held by their qualified intermediary prior to the acquisition date of the new property. The exchange funds can pass to the EAT to cover the purchase price and improvements of the new property. The balance of the funds are given to the EAT as necessary to cover the costs associated with making the improvements.
A reverse improvement exchange occurs when a taxpayer wants to begin improvements on the new property before the sale of the old property. In this situation, funding of the purchase price and improvements needs to be provided to the EAT from a bank or taxpayer loan since the exchange account has not yet been funded. These loans get paid back at the conclusion of the transaction when the exchange funds are used by the taxpayer to acquire the property from the EAT.
Important Facts to Know
The standard rules of 1031 exchanges, including the 45 day identification window and the 180 day completion window, still apply in these situations. It is not mandatory that all the improvements be completed before the 180 day completion window closes, at which time the property must transfer to the taxpayer. However, the taxpayer only gets credit for the value of the improvements that are in place at the time of transfer to the taxpayer. The taxpayer can make additional improvements after the exchange has taken place.
These exchanges are covered by Revenue Procedure 2000-37 – This revenue procedure contains some very taxpayer friendly provisions including:
- The terms of any property improvements contracts between the taxpayer and EAT do not have to be at arm’s length.
- The taxpayer may loan funds directly to the EAT.
- The taxpayer is permitted to guaranty any bank loan made to the EAT.
- The taxpayer may indemnify the EAT for costs and expenses incurred.
- The taxpayer or an agent of the taxpayer may advance funds to the EAT.
- The property may be leased by the EAT to the taxpayer during the parking period.
- The taxpayer may act as the contractor (and receive a fee) or supervise the making of the improvements.
While Rev. Proc. 2000-37 is extremely taxpayer friendly, it is critical to point out that the EAT cannot be the taxpayer, or a related party of the taxpayer. The EAT must be an independent third party. An EAT is usually a newly formed single-member LLC set up under the Qualified Intermediary being used to administer the exchange. Though once that structure is set up, the taxpayer can engage in any of the listed activities above with the EAT.
Due to the flexibility afforded by Rev. Proc. 2000-37, improvement exchanges are a great way to accomplish tax deferral under IRC. Sec 1031 if a taxpayer is unable to find a higher cost property in which to reinvest.
Improvement exchanges can be used to customize property to their liking while utilizing 1031 exchange funds they must reinvest to achieve tax deferral. Many qualified intermediaries (QIs) offer EAT services. It is imperative that you research potential QIs before beginning the exchange process to ensure they are capable and competent in administering the process.
The 180 day completion window does not allow much lead time in completing the construction, thus prudent planning should be done before entering any transactions. Section 1031 exchanges are one area of the tax code that continues to draw significant attention from Congress and the IRS, and they could be on the chopping block whenever tax reform occurs. Anyone considering disposing of property and wishing to achieve tax deferral under IRC Section 1031 should move quickly.
©2016 RIA Checkpoint
Edwards, Martin. “Can Property Improvement Costs Be Part of a 1031 Tax Deferred Exchange.” www.accruit.com/1031-news
“Overview of the Improvement 1031 Exchange.” www.exeter1031.com
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.