Improvement Exchanges vs. Traditional 1031: A Guide to Build-to-Suit and Construction Exchanges

THE TL;DR Version:

Let’s say you purchase a replacement property but want to renovate it. Is that possible? An improvement exchange, also referred to as a build-to-suit or construction exchange, lets you use exchange proceeds to improve the property. This is typically done through an Exchange Accommodation Titleholder (EAT) under IRS Revenue Procedure 2000-37. Only improvements completed and in place before the exchange deadline can be counted toward the exchange value, and the exchange must be completed by the earlier of 180 days, or the due date of the taxpayer’s return, including extensions.

What Exactly is an Improvement Exchange?

An improvement exchange, or build-to-suit exchange, allows real estate investors to enhance and improve replacement property using funds from a 1031 exchange to achieve tax deferral. The structure typically requires an Exchange Accommodation Titleholder (EAT), a third party that holds title to the replacement property while construction is completed, in compliance with IRS Revenue Procedure 2000-37.

The investor can only include the value of any improvements finished prior to the exchange deadline in the replacement property’s exchange value, and the property must be transferred to the investor within that time. This differentiates improvement exchanges from traditional 1031 exchanges, and careful time management throughout the process is crucial.

What is an Exchange Accommodation Titleholder?

When considering improvement exchanges vs. 1031 forward exchanges, EATs are key. This is a third-party entity, like First American Exchange Company, that temporarily holds title to the replacement property while construction or renovation is underway.

The EAT should be a properly structured accommodation party that fits within the safe harbor rules established by IRS Revenue Procedure 2000-37, and is not a disqualified person under the exchange regulations. Once all improvements are completed or the 180-day exchange window is over, title transfers from the EAT to the investor, completing the improvement exchange.

What Are the Two Types of Improvement Exchanges?

Since there isn’t a one-size-fits-all approach to these types of exchanges, depending on the transaction, the final structure may take one of two forms:

1. Forward Improvement Exchange: This is the most common structure for an improvement exchange. The investor first sells the relinquished property. The EAT then acquires the replacement property and oversees construction. Exchange proceeds fund the acquisition and improvement costs, and ownership transfers to the investor once construction is complete (or the 180-day window is over).

2. Reverse Improvement Exchange: In this type of improvement exchange, the EAT acquires the replacement property before the relinquished property is sold. This can be useful when a time-sensitive acquisition opportunity comes up, or when the investor needs to begin construction before a buyer is secured for the relinquished property. The investor must be able to come up with the cash to loan the EAT for the acquisition and initial improvement costs. These amounts can later be repaid with proceeds from the sale of the relinquished property.

Key Rules to Consider With Improvement Exchanges

One of the biggest risks for investors is not following the core 1031 rules plus the added requirements of the improvement exchange structure. Here is what you need to know:

1. EAT Independence: The EAT you choose must be a genuinely independent third party. Using an EAT that does not satisfy the safe-harbor and disqualified-person rules can jeopardize the exchange.

2. IRS Revenue Procedure 2000-37 Safe Harbor: Safe harbor treatment under Rev. Proc. 2000-37 requires, among other things, a written Qualified Exchange Accommodation Agreement (QEAA) executed within five business days after the EAT acquires the replacement property.

3. Like-Kind Properties: Like traditional 1031 exchanges, improvement exchanges also require a like-kind replacement property. Exchange proceeds may only be used to pay for items or costs resulting in improvements that, when affixed to the property, also constitute like-kind property.

4. 45-Day Identification: The standard 45-day rule still applies to improvement exchanges. The replacement property must be identified in writing within 45 days, and in an improvement exchange the identification should describe both the property and the planned improvements with enough detail to match the intended exchange structure.

5. 180-Day Completion: All improvements must be substantially complete, and the property must be transferred from the EAT to the investor within the 180-day exchange period. Improvements completed after the exchange deadline generally will not count, and the exchange period ends on the earlier of 180 days or the due date of the taxpayer’s return, including extensions.

What Improvements Qualify for These Exchanges?

Not every dollar spent on improvements or renovations to a replacement property necessarily qualifies for tax deferral. Generally, qualifying improvements are those that:

• Are permanently affixed to the real property: Think structural additions, new construction, building systems, or similar capital improvements. Personal property items likely will not qualify.

• Add to the real property’s value: Routine maintenance and repairs generally do not increase the value counted toward tax deferral in the exchange in the way capital improvements do.

• Are funded through the exchange structure: Improvements that are independently financed, either by the investor or another party, may not qualify for the exchange.

• Are completed and in place by 180 days: If your desired improvements are still in progress after 180 days, they won’t count towards the improvement exchange.

Common examples of qualifying improvements include new construction on vacant land, structural additions to existing buildings, HVAC and building system upgrades, and significant interior build-outs that become part of the real property.

If you’re in the market for an improvement exchange, connect with the First American Exchange Company team to discuss your options.

FAQs

What is an improvement exchange?

Compared to traditional 1031 exchanges, an improvement exchange allows an investor to use exchange proceeds to fund improvements or construction on a replacement property before taking title.

What is an EAT in an improvement exchange?

An EAT, or Exchange Accommodation Titleholder, is an independent third-party entity that temporarily holds title to the replacement property while construction is underway. They operate under the safe harbor of IRS Revenue Procedure 2000-37.

Can you use 1031 proceeds to renovate a replacement property?

Yes. Qualifying improvements to a replacement property made within 180 days can be eligible for tax deferral.

What is Rev Proc 2000-37?

IRS Revenue Procedure 2000-37 establishes the safe harbor framework for improvement exchanges. It provides a safe harbor under which the IRS will treat an EAT as the beneficial owner of parked property held under a QEAA.

What happens if construction isn’t finished within 180 days?

Improvements completed after the 180-day window generally will not count toward the value of the replacement property received in the exchange for tax deferral purposes.

What if an investor wants to build improvements on land owned by a related party or on a ground lease?

A Leasehold Improvement Exchange can be considered. Rather than acquiring simple title to a replacement property, the investor exchanges into a long-term leasehold interest and uses exchange proceeds to fund improvements on that ground lease. A leasehold interest generally must have 30 years or more remaining, including renewal options, to be treated as like kind to a fee interest.