Can You Use a 1031 Exchange for New Construction or Property Improvements?
Key Takeaways
1031 exchanges can fund new construction or property improvements, but only through a structured Construction or Improvement Exchange.
From the sale date, investors have 45 days to identify the replacement property and 180 days to complete the exchange, including any planned improvements.
The replacement property is held by an Exchange Accommodation Titleholder (EAT) during construction.
Risks include strict timelines, project delays, and compliance complexity.
For passive investors, Delaware Statutory Trusts (DSTs) offer an alternative way to access real estate without the burdens of property management.
A 1031 exchange allows investors to defer capital gains by reinvesting proceeds into like-kind real estate, but finding the right replacement property on a short timeline isn’t always simple. In competitive markets, the ideal asset may not exist yet—or may require upgrades to meet an investor’s goals. That’s where a construction or improvement exchange can help. These structures allow investors to use exchange funds to build or improve a property during the exchange period, provided strict IRS rules are followed.
This article explains how construction/improvement exchanges work, potential benefits, and how to stay compliant.
What is an Improvement Exchange?
An improvement Exchange—also called a construction exchange or “built-to-suit” exchange—allows an investor to use 1031 exchange proceeds to build new improvements or renovate a replacement property during the exchange period.
Instead of purchasing a finished asset, the investor identifies the land or existing structure along with the planned upgrades, while a Qualified Intermediary (QI) and Exchange Accommodation Titleholder (EAT) manage the exchange funds and hold title during construction. Once the improvements are completed and conveyed within 180 days, the investor can defer taxes under standard 1031 exchange guidelines.
How a Construction or Improvement Exchange Works
A Construction or Improvement Exchange follows the same basic rules as a standard 1031 exchange: investors must adhere to IRS timelines, use a Qualified Intermediary (QI), and meet like-kind requirements. The standard exchange process typically includes:
Engage a Qualified Intermediary (QI): The QI holds the proceeds from the sale of the relinquished property.
Sell the investment property: Sale proceeds are transferred to the QI.
Identify replacement property within 45 days: Investors must formally identify potential like-kind properties in writing. For improvement exchanges, investors must also include both the land and the specific improvements to be made.
Acquire replacement property within 180 days: The exchange must close within this window to qualify for tax deferral.
Report the exchange: File IRS Form 8824 with your tax return to document the transaction.
Key Difference: In an improvement exchange, the replacement property may require construction or renovations. During this process, an Exchange Accommodation Titleholder (EAT) temporarily holds title, and the QI can distribute funds directly to contractors. For the exchange to fully defer capital gains, the combined value of the land plus improvements must equal or exceed the value of the relinquished property. Only the improvements completed and conveyed within the 180-day period count toward the total property value for capital gains tax deferral.
Ownership: The investor cannot hold title during construction; it must remain with the EAT. This prevents taxpayers from “constructively receiving” the property before the exchange is finished, effectively disqualifying the exchange.
Identification: The replacement property and planned improvements must be identified in writing within 45 days of the sale. Too vague an identification (e.g., “improvements to be determined”) may disqualify the exchange.
Timeline: You have 180 days from the sale of your investment property to complete any improvements on the replacement property. This means if you identify your replacement property on day 45, you have 135 days left to complete the construction or renovations, and any unused funds may be taxable as “boot.”
Like-kind requirement: Both the relinquished and replacement property must be real estate held for investment or business use. In general, most real estate in the U.S. is considered “like-kind” to other real estate, including raw land, commercial buildings, and rental properties; however, personal-use property does not qualify.
Equal or greater value rule: The replacement property’s value, including improvements, must be equal to or greater than the value of the relinquished property for full tax deferral. Investors also need to reinvest all net proceeds and replace any debt to fully defer taxes. Any value not reinvested in the replacement property—or any equity or debt not fully replaced—is considered “boot” and is taxable.
What are the Benefits of Improvement Exchanges?
Improvement exchanges offer several advantages for investors looking to maximize the value of their 1031 transactions:
Access to value-add opportunities: Investors can acquire properties that may not yet meet their income or operational goals and use exchange funds to improve or develop them, expanding the pool of potential replacement properties.
Use exchange funds for improvements: Instead of taking on additional debt, investors can apply the proceeds from the sale of their relinquished property directly to construction or renovation costs, reducing financing needs and associated interest expenses.
Tax deferral benefits: As with standard 1031 exchanges, completed and qualified improvements allow investors to defer capital gains taxes, helping preserve more capital for reinvestment.
Flexibility in planning: Improvement exchanges enable investors to target properties that fit specific investment strategies, whether that’s ground-up development, major renovations, or repositioning an underperforming asset.
Risks and Limitations to Be Aware Of
A construction exchange offers potential benefits, but it also comes with risks that investors need to be aware of.
Construction risk: Permitting delays, contractor shortages, or supply chain disruptions can push schedules beyond 180 days. For example, if a contractor finishes only half of a planned renovation by the deadline, the remaining funds could be recognized as taxable ‘boot,’ reducing the amount of gain deferred.
Financing risk: Investors sometimes plan to finance part of the improvements with debt. If interest rates rise or lenders tighten standards mid-project, financing may fall through, leaving the investor unable to complete improvements in time.
Tax risk: If the replacement property’s value falls short of the relinquished property or if identification rules are not followed precisely, the IRS may disallow full deferral.
Market risk: External conditions such as shifting tenant demand or rising construction costs can reduce the expected value-add from the project. Because the equal-or-greater-value rule must still be met, investors have little flexibility if the market shifts mid-project.
Because of the complexity of construction and improvement exchanges, investors should consult their CPA or tax professional—and work closely with a Qualified Intermediary and real estate attorney—to ensure compliance, proper planning, and full tax deferral.
When Does a Construction Exchange Make Sense?
Improvement exchanges may be suitable for investors who want to acquire properties that need development or significant renovations. Due to the added complexity of requiring all improvements in the 180-day strict deadline, these exchanges typically work best when projects are already planned, permits are in process, and contractors are ready to execute.
Investors may consider an improvement exchange if they are interested in
value-add opportunities
ground-up developments; or
repositioning underperforming properties
What About Improvements to an Existing Property You Already Own?
You cannot use 1031 exchange funds to improve property you already own. The replacement property must be a new acquisition; applying exchange proceeds to an asset you currently hold disqualifies the transaction. While there are rare, highly complex structures involving leaseholds or parking arrangements, these are uncommon.
Investors should consult their real estate and tax professionals to determine the best approach for their specific situation
Why Investors Consider DSTs for 1031 Replacement Property
Because of the strict 45- and 180-day deadlines in construction or improvement exchanges, some investors look for simpler, more passive ways to complete a 1031 transaction. One option is a Delaware Statutory Trust (DST), which qualifies as like-kind replacement property under IRS Revenue Ruling 2004-86. DSTs allow investors to defer capital gains while accessing professionally managed real estate without taking on construction or renovation responsibilities.
Why investors choose DSTs:
Passive Investment: DSTs allow investors to own a fractional interest in large real estate properties without managing tenants, maintenance, or operations.
Investment-Grade Real Estate: DSTs often hold high-quality, professionally managed properties such as multifamily apartments, office buildings, medical facilities, or industrial/logistics centers. Provides access to investments that may be out of reach for individual investors.
Diversification: DSTs can often include multiple properties that grant investors exposure to varied income streams and asset types without the need for hands-on management.
Things to consider before investing in a DST:
Sponsor risk: Investors rely on the sponsor to manage the property and make operational decisions. Investors should conduct proper due diligence on the Sponsor and management team prior to making an investment.
Illiquidity: DST interests typically cannot be sold or redeemed easily before the property is sold.
Real estate risk: As with any property investment, factors such as market conditions, tenant performance, and property maintenance can affect returns.
DSTs can be a practical alternative for investors seeking a passive, professionally managed approach to 1031 exchanges, especially when construction deadlines or active property management are not appealing.
Plan Carefully for a Construction Exchange
A 1031 exchange can be used for new construction or property improvements, but only with precise planning and execution. Before committing, investors should weigh the potential risks of tight timelines, the complexity of compliance requirements, and whether they prefer a more active or passive role in property management.
This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees, and other expenses. This literature must be accompanied by and read in conjunction with a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results, forward-looking statements and projections are not guaranteed to achieve the results described, and your actual returns may vary significantly. Investments in private placements are illiquid in nature, and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice, and you should consult with your tax advisor, as individual tax situations will vary. Securities offered through Capulent, LLC Member FINRA, SIPC.
Get Our Free eBook!
Sign up for our newsletter and receive a free copy of our eBook.
