Investors often turn to 1031 exchanges for capital gains tax deferrals in their real estate investments. An improvement 1031 exchange is an approach to qualify for this tax deferral, and it can be a valuable resource in various market conditions.
What is an Improvement 1031 Exchange?
An improvement 1031 exchange uses the same principles of a standard 1031 exchange, such as the like-kind rule, for a capital gains tax deferral. The difference in this type of exchange is the investor’s use of capital improvements to the replacement property to make it qualify for the exchange.
An investor must meet various requirements to successfully complete an improvement exchange in the terms of the Internal Revenue Service (IRS). Capital improvements can include a wide range of processes, from building a garage on a residential home to upgrading an HVAC system. As long as the investor uses capital to make these improvements and meets the IRS requirements, they can complete the exchange.
What Are the Benefits of Completing a 1031 Improvement Exchange?
Investors choose improvement 1031 exchanges for various reasons. One of the most notable benefits of this type of exchange is how it can offer tax deferral in a market with limited properties.
If an investor wants to complete a 1031 exchange, but there are very few available properties that meet the exchange requirements, capital improvements offer flexibility. An investor can identify a property that is close in value to their relinquished property and make adjustments as needed to qualify for the exchange.
Another advantage of an improvement 1031 exchange is the increase in market value. While the exchange will use the cost of the capital improvements to determine the value, some modifications may translate to much higher market values. For example, an investor can update a kitchen in a home for $60,000, and this new kitchen can encourage buyers to pay an extra $80,000 on the initial sale price in a few years if the investor decides to sell.
Improvement Exchange Requirements
With the added element of property modifications, an improvement 1031 exchange has additional requirements to consider before committing to the process.
As with a standard 1031 exchange, the time frame is essential to qualify for the capital tax deferral. After you relinquish a property, you have 45 days to identify a replacement property. You have 180 days from the date of the sale to complete the improvements on your replacement property and transfer the title to your name.
While the time frame is critical in every 1031 exchange, improvement exchanges have an additional consideration — the upgrade timeline. When working with contractors, you’ll want proof that the team can complete the necessary improvements in 180 days, about six months.
The value of the property is recognized the day an investor receives the title for the replacement property. The improvements must be complete once the title passes to the investor.
It’s essential to recognize that intentions to complete improvements do not qualify for tax deferral. If, at the end of the 180-day time period, you accept the title of the property with only incomplete labor and materials to signify improvements, these will not classify as real property. An investor can only exchange real property for real property. Labor and materials are services and personal property.
Equal or Greater Value
The determined value of the improved replacement property must be of equal or greater value to the relinquished property. This rule exists in a standard 1031 exchange, but the improvement component complicates the process.
To successfully complete an improvement exchange, you’ll need to determine how much to spend on your property improvements. First, identify how much you made in the sale of your relinquished property. Take the sale price of your relinquished property and subtract the closing costs. This value is what you need to meet or exceed in your exchange.
Now, consider the purchase price of the replacement property and the closing costs. Find the difference between this value and the previously calculated exchange value. The number you calculate is the price of your improvements. You’ll need to determine what improvements you can make in the required time frame that also meet these value requirements.
Improvement Exchange Process
The improvement exchange process requires two key phases — relinquishment and acquisition.
In the relinquishment phase, an investor must inform a qualified intermediary (QI) of their intention to complete an improvement exchange. Once the QI is informed, the investor can locate a buyer for their property, negotiate sale terms and sign the sales agreement.
After signing this agreement, the investor will work with a closing agent to make the sale official. The investor should inform the closing agent of the intention to complete an exchange and give them the QI contact. All parties involved will sign documentation agreeing to the exchange and closing on the sale.
When the sale is officially closed, the relinquished property goes from the investor to the buyer, and the QI holds the proceeds. Once this money is deposited, the relinquishment phase is complete.
Once the relinquishment is complete, the investor should note the date of the sale and the money earned. From this date, the investor has 45 days to identify an exchange property and 180 days to complete the improvements and finish the exchange.
To start acquisition, the investor must locate a property to buy and negotiate the purchase. Once the seller and the investor reach an agreement, they both sign a sales contract that details the intent to complete a 1031 exchange.
After signing the purchase agreement, the investor can officially identify the property in writing and send it to all parties involved in the exchange, including the QI. The identification documents should describe the improvements the investor intends to make and the projected cost.
Once the property is identified, a closing agent closes on the sale. This process involves the QI creating a Limited Liability Company (LLC) that becomes the Exchange Accommodation Titleholder (EAT). Every party involved signs a series of documents agreeing to the exchange and the closing of the sale.
The QI then sends the funds from the relinquishment phase to the seller. The QI holds any remaining funds for the investor during the improvement process to comply with the 1031 exchange rules. The QI will make arrangements to improve the property as the titleholder, and the investor will supervise and review invoices related to the changes.
After paying the titleholder the funding for the improvements, the title transfers to the investor and the exchange is complete.
Learn More About 1031 Exchanges
An improvement 1031 exchange may be your preferred method for tax deferral in some cases. At 1031 Crowdfunding, we offer an extensive inventory of 1031 properties. Though we don’t specialize in improvement exchanges, we do have turnkey solutions for investors looking to execute a 1031 exchange, and our team of experts can guide you through the process.
Become a member today to access our resources and close on sales within the deadline.
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