The 1031 Brief Podcast Ep. 5: Can a 1031 Exchange Pay for Property Improvements? 

What happens when the replacement property you want needs work before it really makes sense for you? In this episode of The 1031 Brief, Ashley Stefan talks with Ken Harris about improvement exchanges, and how investors may use the exchange period to add value to replacement property before taking title. They discuss forward and reverse improvement exchanges, the importance of the 180-day timeline, what improvements actually count toward exchange value, and some of the construction, funding and identification issues that can affect the deal. They also explain why improvement exchanges tend to reward early planning, especially when permits, contractors, financing, and other real-world delays all must fit inside the exchange clock.

Check out the Practical Improvement Exchange Guide.

Listen to the episode on Spotify or Apple Podcasts.

TRANSCRIPT

Ashley Stefan: Today we're picking up where our reverse exchange conversation left off last time. How can an investor buy a property that needs work, improve it during their exchange period, and then receive the improved, higher-value property as their replacement property in a 1031 exchange?

Let's put some simple numbers around this. Let's say an investor is selling a property for a million dollars. They find a replacement property that costs $700,000, but it needs about $300,000 of work done, renovating it for its intended business purpose. A lot of people assume that they can buy the property through the exchange, take title, then do the work after the exchange with the leftover proceeds and treat the entire million-dollar end product as the 1031 replacement property. But the timing and ownership during construction really matter if an investor is trying to maximize the value that they can assign to their 1031 exchange.

Welcome to the 1031 Brief, a podcast from First American Exchange Company. I'm Ashley Stefan. Before we get started, a quick reminder that this podcast is for educational purposes only. Not to provide legal, tax, financial or investment advice. The facts of every scenario vary, so please remember to consult your own tax advisor and legal counsel about your particular investment details.

In our last episode, Anthony Alosi walked us through reverse exchanges and the concept of parking property with what's called an Exchange Accommodation Titleholder, or EAT. And if you haven't listened to that episode, I'd recommend going back and taking a listen, as it's a great companion to this episode.

But in that episode, we discussed the rationale for a reverse exchange approach, including the reasons that it's increasingly a strategic tool being used by investors to help control their timing and their ability to find the perfect property. So we ended that episode with Anthony giving us a quick preview of improvement exchanges, where the same holding structure is used as in a reverse exchange, giving an investor extra time to add value to the property in the form of improvements before they finish their exchange.

And today I'm joined by Ken Harris, who is Vice President and Western Regional Sales Manager with First American Exchange Company. Ken has worked extensively with investors and advisors on the front and back end of these deals, previously managing the reverse exchange team that handles improvement (or as they're sometimes called, build-to-suit or construction) exchanges. So with that, Ken, thanks for being here. And I'm really glad that we get to take the next step in this two-part series with you.

Ken Harris: Yes, thank you. I'm looking forward to expanding on the parking transaction and on the reverse exchange, and then the other tool that you have in a parking transaction: an improvement exchange, which we're going to discuss today. You know, there's a broad range of clients of mine over the years that have benefited from this type of transaction. It could be a small transaction, a remodel, or building a single-family residence or expanding on an office building or building an office building. So all types of investors have benefited from the improvement exchange transaction.

Ashley Stefan: Well, I want to definitely touch on what you said there, that there are lots of different types of improvements that can be done. Sounds like partial or entire buildings. But before we get into the nitty-gritty, I want to start with the investor's typical rationale for choosing this type of exchange structure. Because nobody's waking up hoping to add more layers and nuance to a deal for fun. And exchanges can already feel complicated as it is for investors. So these improvement exchanges are almost always solving some sort of problem, right? Like a value gap where they need to add value to a property that's less valuable than what they sold.

Ken Harris: Correct. Yeah. So when you're doing an improvement exchange, if you've already watched the reverse exchange episode, the purpose of the reverse exchange is to preserve the property for a future sale and 1031 exchange. Well, we're going to do the same parking transaction, use an EAT LLC to park the property. But the purpose of the improvement exchange is to park the property and to add value to it with the capital improvements that they're going to make during the timeframe of the exchange.

Again, it might be something as simple as adding flooring or a roof or an AC unit, or it could be somebody adding an ADU or just building a house. So there are many reasons they can do the improvement exchange and benefit. So you gave the example in the beginning: you're selling for a million and then you're buying something for $700,000, but you know you have $300,000 of capital improvements that can add value to your property. That's where you could benefit if you can get those improvements done within your exchange period. So usually it's to add value, to try to eliminate a tax consequence from a trade-down in value, but it could be to use the exchange funds to avoid some type of debt relief or mortgage boot. So typically it's just to add value and try to avoid a tax consequence through the 1031 exchange transaction.

Ashley Stefan: Got it. And I also want to talk a little bit more about the moving parts of an improvement exchange. You touched on the fact that there's an EAT involved, just like in a reverse exchange: we've got the special purpose LLC that's temporarily holding title. And so in an improvement exchange, that title-holding step creates the window for the construction. The work is getting completed while the investor's not on title yet, the EAT is on title. So who's controlling the property during construction? Who hires and manages the contractor? How is the exchanger or the taxpayer involved? And how much practical control can an investor have when they're trying to manage these improvements but there's some other entity on title?

Ken Harris: Yeah, so similar to the reverse exchange (and I'll probably refer back to that quite a bit during this podcast), the purpose is to avoid the client taking ownership. So to include the value of improvements, you can't buy the property, then improve it, and have that add to your exchange value. So we're avoiding the client from taking ownership by creating this EAT LLC, which takes ownership of it, and then we lease the property back to the client.

So one of your questions is who controls it? This lease that we create is a triple-net lease. That triple-net lease gives full power to the client to control and access the property. And then we're also going to enter a construction management agreement. The construction management agreement, even though we are the titled owner, will authorize the client and give them management of the construction.

So the client has full control of the property through the lease and they're able to manage the construction through the construction management agreement. So yes, we own the property for the purpose of avoiding them taking ownership, but we're giving them control through the lease and giving them control of the improvements through the construction management agreement.

Ashley Stefan: Got it. And so from a practical standpoint, if you're an investor who's preparing to do an improvement exchange, you should be prepared to ask your QI: what are the documents? Is it a lease that allows me to do the work necessary to engage with the contractor? How would you suggest an investor bridges the gaps in communication and makes sure everyone's on the same page, or that their QI has all the information and their contractor understands who has the right to direct them versus the EAT on title? I imagine it's confusing for people.

Ken Harris: It is. I think it is confusing because they're not in ownership, but we give them full control. They have the lease. Sometimes clients might not be able to pull permits without showing they're on title to the property, because they're not on title. But usually that triple-net lease we provide will give them the power to pull permits on a construction project. So yeah, that's something you definitely want to talk through with your accommodator as you're preparing to do an improvement exchange: what documents give me the power and control to proceed with the improvements and manage the property?

And pull in your advisors. You're probably going to hear me say this multiple times today: plan and prepare. Get involved before you get into a situation where you have to identify next week and you just now spotted a property you need to improve. You might be late in the game for doing that. So if you're going to do this, it's best to know early, be proactive, get us on calls, get your CPAs on calls, get your advisors on a call to discuss this and see if it's even feasible for the client to be successful in doing an improvement exchange.

Ashley Stefan: And on the topic of mechanics and getting all your ducks in a row, I wanted to talk again about just the basic mechanics of improvement exchanges, because something we haven't really talked about yet is that they're unique because they can happen in either direction, forward or reverse. So with a forward improvement exchange, the relinquished property sells before the EAT parks title to the replacement property. And in a reverse, of course, it's the opposite.

Can you walk us through those two paths and explain why the order and sequence of events might change the funding mechanisms, and why the two different options might arise?

Ken Harris: Yeah, so there are two options. We call them the forward improvement exchange and the reverse improvement exchange. If you've listened to the reverse exchange episode, you know the reason we're doing the reverse exchange is because the replacement property has to close first, prior to the relinquished property that they want to relinquish through the 1031 exchange. Well, an improvement exchange, we're parking for a different purpose: we're parking it for improvement.

So our most common improvement exchange is where you close first on the property being sold. That would be your forward improvement exchange. And then on a later date, hopefully quickly thereafter, you close on the replacement property. Close first on the sale, funds come into the exchange transaction, and that gives us the ability to use those funds for the acquisition of the replacement property and also for the improvements. The important thing about the forward improvement exchange is you're now tied to the time frames of the forward exchange transaction, which start when you closed on the relinquished property.

So there are situations where you close today on the relinquished property, but you don't close on the replacement property for 30 days. You don't get access to the replacement property for 30 days to start improving. So you've already eaten into your time deadline. Now you only have 150 days to complete improvements. The forward exchange is great because you can use the funds to buy the property, but the timing may be shortened because you're tied to the time frames of the first closing.

The reverse improvement exchange is similar as far as timing: your time frame starts from the first close date. In a reverse improvement exchange, we're parking the property for two purposes: we're parking it as a reverse because the replacement property is closing first, and we're parking it for the improvements also. The benefit to this is timing: you get access to the property for a full 180 days from the acquisition of the replacement property.

The tradeoff is funding, because in the forward improvement exchange we had the funds from the relinquished property to improve. In the reverse exchange, we don't have the funds from the relinquished property yet because it has not closed. So the client has to have the funds and/or third-party financing from a lender. That could complicate things, but gives you more time. So there are pros and cons to both. It really comes down to timing: in a forward exchange, close on the sale first. In a reverse improvement exchange, close on the replacement property first and then later use the relinquished property as part of the 1031 exchange.

Ashley Stefan: So the timing is just so crucial all the way around for these. And kind of continuing down that path, I feel like timing issues are where the realities of actually executing the improvement exchange and the creative ideas that people come up with start to diverge a little. Because on paper, 180 days sounds like a healthy amount of time (it's six months), but in construction time, that clock can just disappear before the first inspection is even scheduled. So in your experience, what tends to take up more time than investors expect when they're trying to go down this path?

Ken Harris: Yeah, I mean, if anyone's ever done a small project on their own home before, I think people realize there are things that could delay you. You have permits, you have inspections, you have inspectors. In an improvement exchange, you may have lenders involved that need approval. There's weather. During the COVID era, we saw shortages of supplies or an increase in supply costs. So a lot of these things play a factor, especially when you only have 180 days.

The idea is to get as much value of improvements done as possible, but if you have a couple of delays (a shortage of supplies, contractors that don't work as fast as they may have told you up front), these can really affect the outcome. The good news is you may get delayed but still benefit from the transaction. Maybe you needed $300,000 done but you only got $200,000 done. There can still be benefits.

As you're planning, you should probably plan for some delays during the process. What weather is coming up? Are we going into winter season? Where do you live? Understanding the permit process is very important. It may take a while depending on the city, county or state that you're in. So understanding that process is critical.

Ashley Stefan: Yeah. And something important that I took from what you said is you might still get value even if you don't finish the improvements. So an unfinished project at the end of an improvement exchange doesn't mean that your exchange fails or anything like that. The practical issue is just that the unfinished work might not count toward the value the investor receives by the deadline for their exchange. Could you give us a visual example of this?

Ken Harris: Yeah, so we'll use your initial example of selling for a million, buying for $700,000. If you just buy for $700,000, you have a $300,000 trade-down and tax consequences on that. So you take $300,000 of improvements, and the 180th day is approaching, but you've only completed $200,000 of improvements. You didn't get everything you intended to complete within the 180-day period. But you completed $200,000. So instead of having a $300,000 trade-down in value, you will now acquire the property back at a $900,000 value: the acquisition price of $700,000 plus the $200,000 of improvements completed within the exchange period. Now you only have a $100,000 trade-down to be concerned about versus the $300,000 trade-down. So you still could benefit from the exchange.

And there are situations where you go into a project knowing you're not going to complete all the improvements; you just have to understand you'll only get the value of the completed improvements during the timeframe of the exchange.

Ashley Stefan: And I know you get this question a lot. What if I have you send all of my exchange proceeds to buy all the materials needed for construction before the deadline to spend the money? Can that work?

Ken Harris): Yeah, I get that quite a bit. Or, we're approaching the 180-day deadline and using that $100,000 example of work you didn't get completed. I'm just going to prepay my contractor, or I'm going to pay for lumber and put it on my driveway, or pay for that AC unit that hasn't been installed yet.

Here's the thing: a capital improvement must be affixed to the foundation or structure of the property. Just buying lumber is personal property, which is not like-kind for a 1031 exchange. You can't just buy lumber and say you improved the property. That value does not count until it is affixed to the property, until it's a structure on the property. So you can't prepay future improvements and benefit on that value because it's not part of the structure, it's not part of the capital improvement, and it doesn't improve the value of the property until it is complete and attached to the foundation.

Ashley Stefan: Okay. So my takeaway is: paid for doesn't necessarily mean completed, and completed doesn't necessarily mean it's part of the real estate unless it's actually affixed and incorporated into the property. For our listeners' purposes, it has to be affixed and finished for that money you spent to actually be part of that final exchange value. Okay.

Ken Harris: Correct. Yeah. It has to be complete. It has to be on the structure of the property. Exactly.

Ashley Stefan: And we also talked about soft costs a little bit. So for anyone listening and starting to wonder: what exactly is a soft cost and what actually counts as a capital improvement? Could you put a little more color on that for additional context?

Ken Harris: Yeah, so a soft cost is, the way I like to think of it, things that need to happen prior to the construction. It may be architecture work, engineering work, permits, surveys, environmental studies. All this stuff that needs to happen that leads up to the construction of the property is what I consider a soft cost. Those are allowable expenses that we could disburse using the exchange funds for the improvement exchange.

But let's say we get to the 180th day and we've only paid for soft costs during the term of the exchange. Because those soft costs didn't lead to actual improvements or actual construction during the timeframe of the exchange, those funds we disbursed for the soft costs are likely going to be considered boot and taxable. Soft costs being paid is okay, but they have to lead to actual construction of the property during the timeframe of the exchange.

Ashley Stefan: Got it, makes sense. Sounds like there's a lot of nuance and investors definitely should work closely with their tax advisor while keeping track of everything and documenting everything. But this conversation made me think of something else. This capital improvement discussion is helpful because there's another technical step that can get overlooked.

In a standard exchange, a taxpayer has to identify replacement property by address or legal description. But in an improvement exchange, the property is changing while the exchange is underway. So they need to identify what they're acquiring. But how do they do that? What should they be thinking about when identifying property and capital improvements to be constructed?

Ken Harris: Yeah. So when you do an exchange, you have to identify the property you're going to acquire. And you must acquire substantially the same property as what was identified. That's important when you're doing an improvement exchange, because by the 45-day identification deadline, you must also submit a list of the improvements you intend to complete during the timeframe of the exchange.

So you're going to identify, say, 123 Main Street, and you're also going to identify the improvements you're going to complete. We want it fairly detailed. You don't want to just say I'm going to build an ADU. You want to say what that entails: I have to lay a cement slab, I have electrical work, I have plumbing, I have drywall, I have lumber, I have a roof, I have an AC unit. So I would list and itemize each thing that's going to happen as you progress in the construction. Be pretty specific on what you identify, and definitely list the improvements you intend to complete during the timeframe of the exchange, not necessarily the soft costs we just discussed.

Ashley Stefan: What you're actually building or renovating or fixing physically, if that makes sense.

Ken Harris: Yeah. I've even had people attach their architectural plans to the identification form. Someone came in recently on an improvement exchange, and they were constructing a retail property, a supermarket or fast food chain building, and they had all their plans ready. When someone comes in like that, I feel comfortable that we could proceed and they could benefit from this.

And this can work too: I had an email this morning from someone who's 30 days into their exchange, identification deadline coming up in a couple of weeks, and they're looking at a property that needs some electrical work and plumbing on a residential property. At that point, I'm thinking: how much is that? Maybe $20,000 worth of work? That may not benefit them, because improvement exchanges do become more expensive, with more out-of-pocket expenses and fees involved. So going back to plan and prepare: I've seen it work where it was last minute and they were able to get improvements done, but it becomes stressful. Plan, prepare, have plans ready. Can you pull permits beforehand? Those things you want to figure out early to be more successful in the improvement exchange.

Ashley Stefan: That's great advice. And in the vein of providing a little preparation for someone who might be interested in doing an improvement exchange, I wanted to talk a little bit about the funding mechanics and get a little more information on who's fronting that acquisition by the EAT, who's fronting the cash for that, who's fronting the construction funds. In a forward exchange, the exchange proceeds can be used for everything. What about in a reverse exchange, and generally speaking, how does it work when invoices come in and need to be paid?

Ken Harris: So I'll kind of answer this twice. In the forward exchange, it's likely that we have money in the exchange account. You close on the relinquished property, we're holding the funds. Those funds are typically used for the acquisition of the replacement property. And often there are excess funds in the exchange account to fund the improvements as well. In that situation, the investor as construction manager is doing the project, getting the invoices, approving them and submitting them to us so we can pay those invoices from the exchange funds we hold on their behalf.

Let's say we deplete all of the exchange funds through the acquisition and the first $100,000 of improvements. Now there are no more exchange funds, but they still need $200,000 more of improvements. In that scenario, as long as we're within the time frames of the exchange, the investor can now start funding the improvements out of pocket.

In the reverse exchange, similarly, we don't have the exchange funds to buy the property or to fund improvements yet. So when we create the EAT LLC to buy the property, the client is essentially depositing the funds, which is basically a loan to the EAT LLC. There's a promissory note as a mechanism to say we can pay those funds back with the future sale and exchange proceeds. So the client funds the acquisition and then continues funding improvements out of pocket as they progress.

In a reverse structure, we don't hold funds. They have to fund out of pocket, but it's a loan to us, and we're allowed to pay them back with the exchange equity from the eventual sale, up to the amount they paid and up to the amount of exchange funds we receive.

Ashley Stefan: Great to understand, although incredibly complex when you talk about it. Sometimes you have to see it on paper. But it's great for listeners to know that if you are doing this in a reverse context, as long as you can front the cash, there is a mechanism to be repaid for those essentially loans to the EAT entity once you sell your property. Of course, there's a risk you don't actually sell the property, but —

Ken Harris: Yes, there's always a risk. You've got to sell the property.

Now, we're going to transfer the property back by the 180th day. That works similar to the reverse exchange because we can only hold it and park it for 180 days. So yeah, there is risk. Going into these, planning and preparing means understanding that risk. The risk of: I may not complete as many improvements as I thought. I may not sell my relinquished property if we're in a reverse fashion. And now what do I do if I own both properties?

Ashley Stefan: Well, before we wrap up, let's end with something practical. If somebody's listening to this and thinks their replacement property needs work and they might need to do an improvement exchange: what information is going to help an exchange team or the investor's financial, tax and legal advisory team quickly figure out whether an improvement exchange is even worth evaluating and what the biggest obstacles could be?

Ken Harris: Yeah. I think one thing to note is that when you're doing an improvement exchange or a reverse exchange, your end game is to complete a 1031 exchange. So we start asking the normal questions. Are you buying of equal or greater value? Are you trading down? Do you have improvements? What is the cost of the improvements? How fast can you get them done? Have you already closed on the relinquished property? Are we in the middle of the time frames?

We're going to talk money, values and possible tax consequences. There are situations where you are trading down, but it may actually make sense for the investor to just take the tax hit on the difference, because these exchanges are quite a bit more expensive than a standard exchange. When a client calls me wanting to do improvements that may only be $30,000, $40,000 or $50,000, it's sometimes best for them to take the tax hit.

There's also the conversation with your CPA about allowable expenses that may offset some of the trade-down or the boot. So there's much more to it than just trading down.

Sometimes they're okay with paying a little tax. Sometimes they didn't understand that allowable expenses could offset it. So we start with value. Are you trading down? Can you buy other replacement property? You could sell for a million and buy two $500,000 properties to meet your value and avoid an improvement exchange entirely. So it's about vetting the transaction, understanding the money, going equal or greater in value, understanding the improvements and how fast they can get done, and discussing all of that with us, your CPAs and any attorneys involved, so that you're planned and prepared.

Ashley Stefan: Well, Kenny, thank you. This was really helpful. Improvement exchanges can definitely create flexibility for people, but the structure is only going to work when the real estate deal and the construction plan are both ready for the same clock. So thank you for highlighting the importance of planning and for being here today. It was a great wake-up call to the realities of planning these transactions, but also a great reminder of the immense value they can unpack for people.

Ken Harris: Yeah, it's a great tool. It really is. I've seen all types of investors benefit from this. So if anything, call us. Let's talk about it and see if it's something you want to entertain, because it is a great tool to help your 1031 exchange transaction and maybe avoid a tax.

Ashley Stefan: Well, with that, for listeners who want to organize the first planning conversation for an improvement exchange, we'll include a practical improvement exchange guide in the show notes. So thank you for listening and see you next time on the 1031 Brief, where we bring you information useful enough to remember and practical enough to use.

This podcast is for educational purposes only and isn't legal, tax, financial, or investment advice. Please consult your own tax advisor and legal counsel about your situation.

This episode is copyright 2026 by First American Financial Corporation, all rights reserved.

This transcript has been edited for clarity.

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