1031 Improvement Exchanges

IMPROVEMENT EXCHANGE

An Improvement Exchange allows the investor to construct the "perfect" replacement property in order to acquire precisely what is desired. Improvements can be as simple as repairs to existing structures or as complex as ground-up new construction. The Improvement Exchange opens up many opportunities to the savvy investor, even the possibility of improvements to property already owned.

IMPROVEMENT EXCHANGE REQUIREMENTS

1031 Exchange requirements must be applied in the Improvement Exchange. This requirement means that all improvements must be constructed within the 180-day time period. With this time constraint, satisfying the "like-kind" requirement may be challenging. When the Exchangor gives up real property, he needs to receive real property in return. If at the 180-day deadline the Exchangor were to receive only unimproved land with labor and materials to be used in the future, the exchange would not be totally tax-deferred. The labor (services) and materials (personal property) are not like-kind to real property. While escrow holdbacks or pre-payment of labor and materials are natural paths in getting improvements done, they do not qualify for tax deferral. The escrow holdbacks and pre-payment of labor and materials are treated as "boot" and are subject to taxation.

The exchange value requirement (Napkin Test) must also be met in the improvement exchange. When the improvements to the replacement property are completed, the replacement property needs to have the same or greater value than the relinquished property.

The following example illustrates how the improvement exchange would be a viable option.

The Exchangor owns a 20-unit apartment building valued at $1.7 million, with $700,000 in debt on the property and $1 million in equity. The Exchangor wants to acquire a medical office building downtown. The type of building the Exchangor wants is currently not available for sale. Fortunately, there is a property for sale in the desired area that has a small vacant retail building on it that can be improved and expanded for office medical suites. The property is available for $1 million and the Exchangor estimates the improvements will cost $700,000. The Exchangor will finance the improvements with a $700,000 construction loan. The Exchangor estimates the improvements to take 5 months and that the value of the improved medical building, when appraised, will be at least $2 million. In this example, the improvement exchange works. The exchange is completed within 180 days and there is an exchange of like-kind property. The value of the improved replacement property (value, debt and equity) are the same as or greater than the relinquished property.

Exchangor's Guidelines to Accomplishing the Delayed Improvement Exchange

Phase I: The Relinquishment

  • Contact Equity Advantage
    • Inform Equity Advantage that it is your intention to participate in a Delayed Improvement Exchange.
    • Equity Advantage provides information to make sure an exchange is beneficial to you.
    • Establish an account with Equity Advantage: provide contact information and any additional property information you know at this time.
  • Locate a buyer for your property or properties
    • Negotiate the terms for the sale.
    • Sign a sales agreement.
    • The agreement must have a paragraph stating the sale is subject to a 1031 Exchange and that the buyer agrees to cooperate with the exchange (1031 Exchange Cooperation Clause).
  • Contact your Closing Agent
    • Provide sale information.
    • Inform closer that the sale involves a 1031 Exchange and that Equity Advantage will be facilitating the exchange and will contact them shortly.
  • Contact Equity Advantage
    • Equity Advantage gathers additional information needed to structure an exchange: property information, closing date, sales price, Buyer’s information, Closing Agent information, etc.).
    • Equity Advantage generates exchange documents and sends them to all appropriate parties.
  • Closing occurs
    • Both parties (Exchangor and Buyer) sign exchange documents drafted by Equity Advantage.
  • Relinquished property title is direct deeded from the Exchangor to the Buyer.
  • Closing Agent forwards the sale proceeds to a federally insured bank designated by Equity Advantage.

This completes Phase I of the exchange. At this point, you have transferred a property to Equity Advantage, and Equity Advantage has sold the property.

Phase II: The Acquisition

  • Review the Identification Packet sent to you by Equity Advantage
    • Equity Advantage creates and forwards an Identification Packet for your review after receiving the Final Settlement Statement from the Closing Agent.
    • The packet contains the following: the relinquished property’s transfer date, the amount of exchange proceeds received, the 45-day identification deadline, and the 180-day deadline to complete the exchange.
    • The identification form provided must be filled out and signed by you, the Exchangor.
  • Locate a property or properties you wish to buy
    • Negotiate the terms for the purchase.
    • Sign a sales/purchase agreement (may be done before or after identifying the property).
    • The contract must have a paragraph stating that the sale is subject to a 1031 Exchange and that the seller agrees to cooperate with the exchange (1031 Exchange Cooperation Clause).
  • Establish funding to acquire intended property
    • The funds may come from your exchange, personal funds, or a bank/lender.
    • If a lender is used to provide the loan, be sure the lender is familiar with the Improvement 1031 Exchange process. (Equity Advantage is available to consult with your lender).
  • Identify the property/properties you wish to buy
    • This must be done by midnight of the 45th day of your exchange period.
    • The replacement property description must include the improvements.
    • Example: “1234 Maple Street, Lake Oswego, OR 97034 with improvements (approx. $45,000), including minor remodel of kitchen and landscaping.”
    • Send the filled out and signed copy to Equity Advantage via fax, mail or email.
    • THE IRS DOES NOT ISSUE EXTENSIONS unless you and/or the property is impacted by a Presidentially Declared Disaster.
  • Contact your Closing Agent
    • Provide purchase information.
    • Inform closer that the purchase involves a 1031 Exchange and that Equity Advantage will contact them shortly.
  • Contact Equity Advantage
    • Equity Advantage gathers the additional information needed to structure an exchange: property information, closing date, sales price, Seller’s information, Closing Agent information, etc.).
    • Equity Advantage then drafts your 1031 Delayed Improvement Exchange documents and creates an LLC as the Exchange Accommodation Titleholder, “EAT.” These documents are sent to all appropriate parties.
  • Closing occurs
    • Both parties (Exchangor and Seller) sign exchange documents drafted by Equity Advantage.
    • Equity Advantage wires exchange proceeds to the closing agent for the purchase of the replacement property.
    • Provide complete funding to the EAT so the EAT may take title to the replacement investment property. The funding is treated as a loan between you and the EAT.
    • A promissory note between the EAT and the Exchangor is secured by a trust deed.

Improvements

  • Execute improvements
    • Documents signed at closing designate the EAT as the owner and provides you, the Exchangor, with the ability to improve the replacement property.
    • This provides you the authority to have access to the replacement property and supervise improvemens to it.
  • Review invoices incurred for improvements
    • Submit invoices to Equity Advantage, with written approval and signature, for payment.
    • The LLC will pay the invoices pursuant to the Exchangor’s written authorization.

At the end of the 180-day period and the completion of improvements, the EAT will transfer title of the replacement property to you. (As a second option, you may choose to keep the LLC and Equity Advantage will transfer its sole membership to you.) The exchange is complete.

Exchangor’s Guidelines to Accomplishing the Reverse Improvement Exchange

The Acquisition

  • Contact Equity Advantage
    • Inform Equity Advantage that it is your intention to participate in a Reverse Improvement Exchange.
    • Equity Advantage provides information to make sure an exchange is beneficial to you.
    • Establish an account with Equity Advantage: provide contact information and any additional property information you know at this time.
    • Establish funding to acquire replacement property The funds may come from your exchange, personal funds or a bank/lender. If a lender is used to provide the loan, be sure the lender is familiar with the Reverse 1031 Exchange process. (Equity Advantage is available to consult with your lender).
  • Negotiate terms of purchase
    • Sign a purchase agreement.
    • The agreement must have a paragraph stating that the sale is subject to a 1031 Exchange and that the Seller agrees to cooperate with the exchange (1031 Exchange Cooperation Clause).
  • Contact your Closing Agent
    • Provide purchase information.
    • Inform closer that the sale involves a 1031 Exchange and that Equity Advantage will be contacting them shortly.
  • Contact Equity Advantage
    • Equity Advantage gathers the additional information needed to structure an exchange: property information, closing date, sales price, Seller’s information, Closing Agent information, etc.).
    • Equity Advantage generates your 1031 Reverse Improvement Exchange documents and sends them to all of the appropriate parties.
    • Equity Advantage creates an LLC as the Exchange Accommodation Titleholder, “EAT.”
  • Provide complete funding
    • Exchangor arranges for all financing for the acquisition of the replacement property.
    • The EAT will take title and make improvements to the replacement investment property.
    • If the EAT is to hold title to the replacement property, the loan must be in the EAT’s name.
    • Provide partial funding to the EAT for the down payment or earnest money deposit that is required by the seller (funding is treated as a loan between you and the EAT).
    • A promissory note between the EAT and the Exchangor is secured by a trust deed.
  • Closing occurs
    • Both parties (Exchangor and Buyer) sign exchange documents drafted by Equity Advantage.
    • The EAT takes title to the replacement property. Improvements may now begin (see “Improvements” below.)

This completes the acquisition of your exchange. At this point, Equity Advantage has either your relinquished property or your replacement property parked.

The Relinquishment

  • Review the Identification Packet sent to you by Equity Advantage
    • Equity Advantage creates and forwards an Identification Packet for your review after receiving the Final Settlement Statement from the Closing Agent.
    • The packet contains the following: the replacement property transfer date, the 45-day identification deadline, and the 180-day deadline to complete the exchange.
    • The identification form provided must be filled out and signed by you, the Exchangor.
  • Identify the property or properties you plan to sell
    • This must be done by midnight of the 45th day of your exchange period.
    • Send the filled out and signed copy to Equity Advantage via fax, mail or email.
    • THE IRS DOES NOT ISSUE EXTENSIONS unless you and/or the property is impacted by a Presidentially Declared Disaster.
  • Contact your Closing Agent
    • Provide sale information.
    • Inform the closer that the purchase involves a 1031 Exchange and that Equity Advantage will be contacting them shortly.
  • Closing Occurs
    • Closing of the relinquished property must occur before the 180-day deadline.
    • Contact Equity Advantage so proper exchange documents are generated.

Improvements

  • Execute improvements
    • Documents signed at closing of the replacement property designate the EAT as the owner and provides you, the Exchangor, with the ability to improve the replacement property.
    • Improvements may be performed up until midnight of the 180th day.
  • Review invoices incurred for improvements
    • Submit invoices to Equity Advantage, with your written approval and signature, for payment.
    • The LLC will pay the invoices pursuant to the Exchangor’s written authorization.

At the end of the 180-day period, the EAT will transfer title of the replacement property to you. (As a second option, you may choose to keep the LLC and Equity Advantage will transfer its sole membership to you.) The exchange is complete.

Do you Qualify? Answer some basic questions to determine whether an exchange is right for you and your current situation.

"WASHINGTON STATE LAW, RCW 19.310.040, REQUIRES AN EXCHANGE FACILITATOR TO EITHER MAINTAIN A FIDELITY BOND IN AN AMOUNT OF NOT LESS THAN ONE MILLION DOLLARS THAT PROTECTS CLIENTS AGAINST LOSSES CAUSED BY CRIMINAL ACTS OF THE EXCHANGE FACILITATOR, OR HOLD ALL CLIENT FUNDS IN A QUALIFIED ESCROW ACCOUNT OR QUALIFIED TRUST." RCW 19.310.040(1)(b) (as amended)