An Important Truth About 1031 Exchanges

By Author: Trisha Coppley
Total Articles: 46
Comment this article

An important truth in regard to conducting a 1031 exchange is that you CANNOT make use of the proceeds of the original sale to make improvements on land you own already. This is a common pitfall of unwary investors. To qualify for a capital gains tax deferral, your replacement property must be of like kind with the property it replaces. For this reason, the property you acquire as a result of the 1031 exchange must constitute real estate with a value at least as high, if not greater than that of the relinquished property. An improvement that is not completed is considered a contract for service, comprising personal estate but not real estate. Because a replacement property has to be equivalent in type and value with the relinquished property upon closing, it can be difficult to find one that complies with these legal requirements but also meets his or her specifications.

So, is there a way to the property of your dreams out of a 1031 exchange? There are two main methods by which you can acquire a property that fulfills your wants and needs and fulfills the accounting requirements necessary for a like-kind exchange ...
... under section 1031

The first possibility is to perform what is known as a poor man's build to suit in which you, as the purchaser, ask the seller to make particular renovations on a property to increase its value prior to closing . To illustrate: if you were to relinquish a a piece of property with a value of $100,000, and were looking at a replacement property valued at ten thousand dollars, the seller could make ninety thousand dollars' worth of improvements to raise the property value. These completed improvements would constitute real estate. You could then buy the property for one hundred thousand dollars, fulfilling the requirement of equivalent value. the majority of sellers, however, will not be enthusiastic to perform these improvements so that you may make an exchange.

In the 2nd, likelier scenario a qualified intermediary who is holding your money buys the replacement property from the seller and take title to it in a limited liability company, intermediary-owned company. Then, the intermediary would make use of what remains of the proceeds to make the necessary improvements on the property. Upon completion, the intermediary transfers the replacement property to you, which then allows you to complete the exchange .

Back to the $10,000 replacement property: the intermediary would buy the aforementioned piece of real estate for the asking price and would make the required renovations using what is left of the funds, transferring the replacement property to you when the property's value is high enough to establish likeness with the relinquished property.

Although a build to suit exchange can go a long towards getting you the replacement property that you really want, it is key to consider the time required for the construction of necessary improvements. You only have 180 days in which to bring a exchange to completion, so it is important to be realistic about what can actually be brought to fruition in this time span. Keep in mind that a renovation represents real estate when it is finished, so a work in progress doesn't increase the value of the property. Although you might not be able to construct improvements as extensive as you might want, 180 days is ample time to finish significant improvements, and to bring your replacement property that much closer to the property of your dreams.