It is common for an Exchangor to make improvements to a newly acquired property in order for it to realize its full investment or use potential. It is possible to structure an exchange so that improvements can be made to property parked in an EAT before the Exchangor actually takes title. This structure is called an "improvement exchange". The objective is to increase the value of the New Property by making improvements to it that will be considered "like-kind" when the Exchangor acquires it from the EAT at the conclusion of the exchange. The improvements can be made during the 180-day period following the start of the exchange. The value of the improvements is the sum of the applicable costs and expenses incurred during the exchange period.
The basic improvement exchange has two variations. The first variation involves a standard Exchange Last in which the Old Property is sold after the New Property is acquired by the EAT. The second variation involves the sale of the Old Property first as part of a forward exchange and the subsequent acquisition of the New Property by an EAT. We will see below that the method used to finance the improvements is an important consideration that affects the choice of variation. A second important consideration is the timing. The timeframe available for making improvements to the New Property in the first variation is 180 days from the acquisition of the New Property by the EAT; in the second variation, the 180-day window begins with the sale of the Old Property. There can be a meaningful difference in the time available to make improvements if the acquisition of the New Property is delayed when the second variation is used.
The first variation is a standard Exchange Last in which the New Property is acquired and held by an EAT on behalf of an Exchangor. The EAT borrows funds from the Exchangor, using an interest-free loan, and possibly a third-party lender to finance acquisition of the property and the construction of the improvements. The EAT may also lease (rent-free) the New Property to the Exchangor and hire the Exchangor (no fees) as the Construction Manager to oversee the making of the improvements. The 45-day ID requirements are satisfied using Old Property owned by the Exchangor. Once the Old Property is sold and the improvements are finished or 180 days transpires, a standard 1031 exchange is done and ownership of the improved New Property transfers to the Exchangor. The value of the New Property will be the sum of the initial purchase price of the (unimproved) New Property, the price of the improvements made during the exchange period and any normal ancillary costs. For real property, the improvements do not have to be completed in the 180 day period and it is the value of the improvements made during that period that are included in the purchase price of the New Property.
For example, suppose in an exchange of real property, the Old Property has a FMV of $2million and is to be exchanged for a New Property with an acquisition price of $1.5million. Assume also that there is a plan to spend $800,000 on improvements to the New Property in order for it to achieve its full investment potential. Without an improvement exchange, there will be $500,000 in taxable boot. Suppose further that the Exchangor begins a reverse exchange by having an Accommodator acquire the New Property on its behalf and spends $700,000 on the needed improvements during the 180-day exchange period. If the Old Property is sold during the same period, then the deferment of the gain on the $500,000 difference in purchase prices will be accomplished and the balance of the improvements can be made after the conclusion of the reverse exchange.
The second variation involves the sale of the Old Property using a QI in the context of a delayed exchange as the first event. Subsequently, perhaps on the same day but perhaps later, the EAT will acquire the New Property and begin making the improvements. The funds held by the QI can be used by the EAT to acquire the New Property and/or to finance the improvements as long as they do not come under control of the Exchangor. This is done by forming an arrangement between the EAT and the QI, with the consent of the Exchangor, whereby cash draw requests made by the EAT to pay costs pertaining to the improvements are satisfied with the exchange proceeds held by the QI. The Exchangor may also provide a separate source of funds to the EAT by either lending additional funds to it directly or arranging for third-party construction financing. The ID requirements must be met within 45 days of the sale of the Old Property and usually are met by identifying the unimproved New Property and providing a plan or description of the improvements. Improvements made during the 180 day period following the close of the Old Property sale will count toward the value of the New Property if the exchange involves real property. If the exchange involves personal property, the "substantial completion" requirement must be met as well in order for the New Property to be deemed like-kind to the Old Property.
For example, supposed an Exchangor has an Old Property with a FMV of $3million and $1million in debt. Suppose further that the Exchangor wants to exchange it for land on which an apartment building will be built. If the price of the land is $1.5million and the estimated cost of building is $2million, an improvement exchange can be employed to defer some or all of the gain from the sale of the Old Property. Suppose that the Old Property is sold as part of a delayed 1031 exchange and that the land is scheduled to be acquired a week later. An arrangement between the QI holding the proceeds of the Old Property sale, the EAT and the Exchangor can be formed by which the funds held by the QI are used to acquire the land and, further, by which some of the improvements to the land can be financed. A further arrangement between the Exchangor and the EAT will be required for any additional funds to be used for the improvements. If the Exchangor contributes another $1million in cash or arranges for $1million in debt, then a full deferment of gain will likely occur, as long as the expenses toward the improvements are all made with 180 days of the sale of the Old Property.
The issues raised by differing approaches to funding the improvements can add considerable complexity to an improvement exchange and potential users of this strategy are advised to consult with an experienced Accommodator to determine an optimal course of action.
A very useful variant of the improvement exchange is the leasehold improvement exchange. If, for example, vacant land is owned by an affiliate of the Exchangor, then it may be possible to make improvements to the land using funds provided by the Exchangor and have the improvements considered like-kind to real estate for 1031 exchange purposes. For this variation to work, it is critical that the affiliate is an entity that has its own tax identity and that it holds title to the land. The Exchangor should not have held title to the land for the 180 day period preceding the start of the exchange process. The exchange process involves the formation of an EAT that enters into a long-term lease (at least 30½ years) for the land with the Affiliate. The EAT agrees, as part of the lease, to make and own certain improvements that will be financed by the Exchangor and to pay rent at a market rate. Once the sale of the Exchangor’s Old Property is about to close, a 1031 exchange will be executed in which the New Property will be the long-term lease for the land and the improvements made to it by the EAT. The transfer of the New Property to the Exchangor occurs via an assignment of 100% of the membership interest in the EAT. The value attributed to the leasehold will be zero while the value of the improvements will be established by the amount of money spent during the exchange period.
For example, suppose that the Exchangor (an individual) is a principle in a family Limited Partnership ("LP") that owns vacant land. Suppose further that the Exchangor holds title directly to Old Property it intends to sell with a FMV of $3million. The Exchangor’s desired strategy is to construct an apartment building, with costs estimated at $4million, on the land using the proceeds from the sale of the Old Property while deferring the gain on its sale. The Exchangor engages an Accommodator that forms an EAT and the EAT enters into a 31 year lease of the land from the LP that requires fair-market rent to be paid to the LP. The EAT also begins to build the apartments using other funds provided by the Exchangor and manages to spend $3.5million during the 180-day exchange period. Once the Old Property is sold, an exchange can be done in which the Exchangor receives 100% of the interests in the EAT as New Property. The value of the New Property will be $3.5million, the value of the improvements, with the leasehold itself contributing no value.