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.

A reverse exchange is the purchase of the Replacement Property prior to closing on the Relinquished Property. An Investor may need to consider a reverse exchange in a situation where the Replacement Property must be acquired before the Relinquished Property can be sold.  Due to increased transaction and exchange costs associated with a reverse exchange, IES strongly recommends that Investor first exhaust all options to delay closing on the Replacement Property until the closing on the Relinquished Property has occurred.  Some possible ways to delay closing on the Replacement Property include:

1. Putting up more non-refundable earnest money to buy a closing extension.  Again, it may be cheaper to pay for an extension that to pay the Intermediary the additional costs associated with a reserve exchange.
2. Leasing the Replacement Property with an option to purchase that would trigger upon sale of the Relinquished Property.  This approach has the duel advantage of allowing Investor access to the Replacement Property and giving the Seller some rental income while they wait for the Relinquished Property to sell.

Revenue Procedure 2000-37 (finalized on September 15, 2000) provides the framework to safely perform a reverse exchange.   The most common variation of a reserve exchange allowed under Revenue Procedure 2000-37 (often called “replacement property parked” or “exchange last”) involves an entity referred to as an “accommodating title holder” or “AT” first purchasing the Replacement Property. When the Relinquished Property is sold at a later date, the AT completes the exchange by deeding the Replacement Property back to the Investor.  During the AT’s ownership, the Replacement Property is leased to Investor in order to give Investor the beneficial use of the Replacement Property during the exchange period.

The AT will usually be a single purpose limited liability company owned and managed by IES. The following agreements are permissible regardless of whether or not they contain terms which may typically destroy an arms length relationship between the EAT and the Investor.

1. The AT may act as both the qualified intermediary and the AT.
2. The Investor may guarantee all or part of the obligations of the AT including debt and incurred expenses.
3. Investor may loan or advance funds to the AT and not charge interest on these amounts.
4. The AT may lease the property to Investor at below market rates.
5. The AT may enter into a management agreement with the taxpayer at below market rates.  Typically, the lease or management agreement will provide enough income to the AT to satisfy their debt services payments under bank financing as well as covering all operating expenses for the Replacement Property.
6. The Investor may act as contractor and/or supervisor with respect to the Replacement Property if improvements are going to be constructed.
7. AT and Investor may enter into agreements using puts and calls at fixed or formula prices for subsequent dispositions in the event the exchange cannot be completed within the 180 day period.

An “exchange last” transaction can be illustrated as follows:

Click here to download Reverse Exchange Outline PDF

In the event that the Relinquished Property cannot be sold within the 180-day period following the AT’s acquisition of the Replacement Property, the QEAA provides that the Relinquished Property will be transferred back to Investor subject to the acquisition debt.  The subsequent sale of the Relinquished Property after the 180-day period could still be structured as a 1031 exchange provided that Investor acquired “like-kind” property other than the Replacement Property that was parked by the AT as part of the reverse exchange.

In a reverse exchange, it is especially crucial that you select an Intermediary who has the experience and knowledge of the steps and precautions necessary in these complex transactions.
Also, it is critical to engage the Intermediary well in advance to the purchase of the Replacement Property in order to allow sufficient time to work with the lender’s, attorneys, and closing agent involved.  Working with an Investor’s tax advisors and attorneys, IES draws upon substantial experience with reverse exchanges to help lead the investor safely through a minefield of potential hazards.