It is common for real estate investors to invest in a fixer-upper in order to build value by making needed improvements. By following the guidelines in this blog, it is possible to use exchange funds to improve a 1031 exchange replacement property. Let’s first discuss the general rules that would allow investors to sell a fixer-upper property and defer taxes through a 1031 exchange.
IRS guidelines will generally allow a 1031 exchange tax deferral to be utilized if the property was purchased with “an intent to invest.” Conversely, a 1031 exchange would not be permitted if the property was purchased with “an intent to sell.” This distinction can be confusing since there is no clear explanation of how to determine the difference between these intentions in the tax code.
Investors and their tax advisors are left to rely on industry practices and follow past examples of what was previously allowed by tax authorities.
Clear-cut examples of properties that would not qualify for a 1031 exchange would be 1) new homes built by a developer and then sold 2) fixer-uppers that are sold shortly after being rehabbed. Tax authorities treat these types of properties as being inventory or stock in trade and do not allow a 1031 deferral of taxes due upon sale.
Properties that are acquired with “an intent to invest” that could qualify for a 1031 exchange include rental properties and other forms of real estate where the investor plans to hold them for longer term income and/or appreciation.
Many tax advisors advise investors to hold replacement properties for a minimum of two years before reselling them.
Converting Construction Materials into Like-Kind Property
Regular readers know that 1031 exchange funds can only be invested in “like-kind” qualifying real estate properties. So, if the investment plan is to improve a property, under what conditions can 1031 exchange funds be used to purchase construction materials that are not considered to be “like-kind” at time of purchase?
For example, if you purchase lumber, at what point does it become real estate? Items needed for construction such as lumber, cabinets, plumbing, etc., become part of the real estate when they are attached to the real estate. Only then are these items considered to be “like kind” property.
It then seems reasonable to conclude that exchange funds can be used to make improvements to a 1031 replacement property. Right? Not so fast as we will discuss below.
Timing is crucial when it comes to tax-deferred transactions. The exchange is complete when the investor receives title to the replacement property. Even if the money comes from the sale of the property that was given up, later renovations will not be eligible for tax deferral.
We often receive questions regarding the use of exchange funds to pre-pay for building services that will be rendered at a later time or to buy items that won't be installed in the replacement property until after the closing. Even if the payments are made through escrow as a part of the acquisition of replacement property, the answer is "no" in both situations.
The 1031 exchange process concludes when the investor completes the purchase of the replacement property. All materials related to improvements must be completed and be a part of the real property at the time funds are reinvested in order to be eligible for tax-deferred treatment. Similar to the replacement property, any construction work must be finished before closing.
Meeting Timing Requirements
There are two common solutions for meeting 1031 timing requirements while improving replacement properties.
The first is to have the seller complete the renovations before you conclude the acquisition of the replacement property. The purchase agreement can be set up so that the Qualified Intermediary pays exchange proceeds directly to the seller for the upgrades or as additional earnest money deposits.
If this is not an option, an Improvement Exchange is another option. An Improvement Exchange, like a Reverse Exchange, calls for a third party unrelated to the buyer to temporarily acquire title to the replacement property. The Qualified Intermediary or an affiliate normally fulfills this role and would then assist to oversee completion of the planned renovations per IRS guidelines.
In both of these cases, improvements must be completed within 180 days of the closing of the sale of the relinquished property.
It is important to take care to properly identify the replacement property before construction begins on any improvements. Simply identifying the underlying real property is insufficient. Identifying the upgrades is also important, particularly if they may alter the property's fundamental nature or character.
Example: “1234 Maple Street, San Jose, CA 95112 with improvements (approximately $80,000), including remodel of kitchen, one bathroom, and landscaping.”
An Improvement Exchange is more expensive than a standard exchange and requires careful planning and execution. It is very important to not only work with a Qualified Intermediary who has significant prior experience with improvement exchanges but to also follow the guidance of a knowledgeable real estate tax advisor on related tax planning matters.
Using exchange funds to create a more valuable rental property can be an excellent investment strategy. Well-chosen improvements can result in greater demand from tenants which can translate into higher rental income and appreciation potential.
For more information on real estate tax deferral strategies and to obtain referrals to experienced real estate tax advisors and Qualified Intermediaries who can help you with Improvement Exchanges, please contact us at 866 398-1031.
1. Changes to irrevocable trusts usually require approval by all the beneficiaries and/or a court to that may be granted if beneficiaries can prove that significant changes occurred requiring a change e.g., changed tax laws.