Improvement (build-to-suit or construction) exchanges allow an Investor to use Exchange Proceeds to either (1) make improvements to an existing property or (2) build a new replacement property. This variation is extremely popular because it provides the opportunity to purchase properties needing renovation or to acquire bare land and build to an Investor’s exact specifications. The Intermediary makes improvements to the replacement property during the exchange period and transfers the improved property back to the Investor prior to the expiration of the 180 exchange period. Advance planning is essential; normal construction delays, inclement weather and obtaining government permits can make it a challenge to complete the needed improvements within the 180-day exchange period.

The typical steps for an improvement exchange are as follows:

  1. Investor completes the sale of the Relinquished Property as a 1031 exchange with the Exchange Proceeds being conveyed to the Intermediary at closing.  The Exchange Agreement utilized in an improvement exchange will be different than that associated with a delayed exchange in that it will authorize the Intermediary to construct improvements to the identified replacement property.
  2. Investor identifies the Replacement Property to be acquired within the 45-day identification period.  The identification must include a description of the improvements that will be completed to the Replacement Property within the 180-day exchange period.  It is recommended that a copy of the constructions plans and specifications be attached to the identification.
  3. Intermediary will form a special purpose entity (usually a single member limited liability company) to serve as an accommodating titleholder (“AT”).  The AT will acquire the Replacement Property and hold title until completion of the improvements or expiration of the 180-day exchange period, whichever occurs first.  The AT will be owned by Intermediary during the 180-day exchange period.  The AT will utilize the Exchange Proceeds being held by the Intermediary to acquire the Replacement Property.
  4. AT will enter into a Construction Management Agreement with Investor that authorizes Investor to enter into the Construction Contracts for the completion of the improvements and oversee the construction of the improvements during the 180-day exchange period.
  5. Intermediary will utilize any Exchange Proceeds remaining after acquisition of the Replacement Property to pay for the costs associated with constructing the improvements to the Replacement Property.  Investor will authorize payment from the Exchange Proceeds to the various contractors and subcontractors completing the improvements.  Intermediary will make payments directly to the contractors and subcontractors from the Exchange Proceeds.  If financing is utilized to complete the acquisition of the Replacement Property and construction of the improvements, it is imperative that the loan initially be taken in the name of the AT.  Coordination with the acquisition and construction lender is critical in an improvement exchange.
  6. Upon the earlier of (i) construction of the improvements to the Replacement Property or (ii) expiration of the 180-day exchange period, AT will convey the Replacement Property and improvements to Investor to complete the exchange.  For purposes of the exchange, Investor will be treated as having received Replacement Property valued at the initial acquisition cost plus the value of improvements completed within the 180-day exchange period.
  7. The tax benefits of an improvement exchange are illustrated as follows:
    Assume that Investor sells Relinquished Property valued at $500,000 and desires to purchase vacant land for $200,000 and contract a $500,000 building on the land to be held for investment.  Investor desires to have the land and improvements constitute the Replacement Property to be received in the exchange.  If Investor completes a normal delayed and exchange and utilizes $200,000 of the Exchange Proceeds to acquire the land, Investor will be unable to utilize the remaining Exchange Proceeds to make the improvements on a tax deferred basis due to the rule that an Investor cannot utilize Exchange Proceeds to improve property they already own.By utilizing an improvement exchange, title to the land will initially be taken by the AT.  Assuming that $300,000 of improvements can be completed to the Replacement Property within the 180-day exchange period, Investor will be treated as having received Replacement Property valued at $500,000 and will realize full tax deferral with respect to the exchange.
  8. Improvements to the Replacement Property do not need to be 100% complete within the 180-day exchange period in order to be considered like-kind property for purposes of the exchange.  However, Investor will only be credited for the value of improvements that are actually completed within the 180-day exchange period.  Completed improvements are improvements that constitute real property.  In other words, Investor would receive credit for framing that was completed prior to the 180-day exchange period but would not receive credit for prepaid lumber stored on the site that had not yet been incorporated into the improvements.  This is because materials and fixtures aren’t considered to be personal property until they are affixed to the real property.