Can you 1031 Exchange into capital improvements?

Question

Is there a way to sell through a 1031 Exchange but then put the proceeds directly into a bunch of capital improvements at an already-owned like-kind property? This way you do not necessarily need to identify a new property within the time limit. And if so, would you have to disburse all that capital within a certain amount of time?

Dave Foster · Answer

@Ethan Borshansky, There was a brief period of time in the early 2000s when this type of "leasehold exchange" as described above was fairly common.  There's been no outright "outlawing" of them.  But the IRS has made it clear that they are leary of these and not big fans.  Now these are seen as both risky and exorbitantly expensive to comply with all of the nuance in the PLRs.  Unless you've got deep pockets, a thirst for the edge, and are lawyered up it's probably not something you want to attempt.  By themselves, improvements to property you own are considered to by personal property and not real property.  So they don't qualify for a 1031 exchange.

Bill Exeter · Answer

Actually, it is possible do structure a 1031 Exchange on the sale of one or more relinquished properties and then using the proceeds through the 1031 Exchange to construct improvements on real property you already own.  However, there is no way to do so without risk.The Internal Revenue Services issues three (3) Private Letter Rulings (PLRs) that allowed the taxpayers to do just this.  The PLRs and Risks are discussed below.

The general idea is that you must acquire an interest in real property you do not already own, and since you already own the subject real property you want to build on, the transaction must be structured so that you are creating an interest in real property you do not already own (in fact, it does not yet exist).  Essentially, your new replacement property will consist of (1) a thirty plus year ground lease on the real property you already own; and (2) new capital improvements made on the real property you already own pursuant to the new thirty plus year ground lease.  The new ground lease and capital improvements represent the interest in real property you do not already own (and that is being created through this transaction).  These structures are significantly more complicated than a typical 1031 Exchange structure and there are inherent risks involved in the transaction, some of which are discussed below.  You and your legal, tax and financial advisors should review this transaction in greater detail, especially the PLRs, to ensure you understand the significant risks involved and are structuring the transaction as close as possible to the PLRs to mitigate some of the risks.

This transaction involves the sale of your relinquished property through a Qualified Intermediary.  The Exchange Accommodation Titleholder ("EAT"), often a sister company to the qualified intermediary, will form a single-member limited liability company and disregarded entity or ("SMLLC") to serve as the lessee.  You will lease the real property that you already own to the SMLLC.  This thirty plus year ground lease begins to create an interest in real property that did not exist before.  The SMLLC will begin construction of the capital improvements on the real property you already own in the name of and on behalf of the SMLLC.  The thirty plus year ground lease plus the new capital improvements made to or on the real property leased by the SMLLC creates and represents the new interest in real property that you will be identify and acquire as your replacement property in your 1031 Exchange.

RISKS

Private Letter Rulings

There are three (3) Private Letter Rulings (“PLRs”) that address this 1031 Exchange structure, which are as follows:

Private Letter Ruling Number 2014-08019Private Letter Ruling Number 2003-29021Private Letter Ruling Number 2002-51008

PLRs can only be relied upon by the individual taxpayers that requested the PLRs.  PLRs can NOT be used or cited as precedent should you be audited, and it is always possible that the IRS could still disallow this 1031 Exchange.  PLRs will rarely match your proposed transaction structure.  Deviations from the PLRs will significantly increase the risk to you since your transaction did not follow the PLRs exactly.

Deviation from Private Letter Rulings

There are a couple of areas where transactions deviate from the three (3) Private Letter Rulings discussed above.  First, the three (3) Private Letter Rulings will likely not be directly on point, so there will be some inherent risk in that you will not be able to follow the Private Letter Rulings exactly as they were issued.  Second, the ownership of the relinquished property and the replacement property in the three (3) Private Letter Rulings involved two distinctly different taxpayers.  The relinquished property was owned by one taxpayer and the replacement property was owned by a different taxpayer, although related parties or entities.  The ownership of your relinquished property and your replacement property may be owned or held by the same taxpayer as opposed to different taxpayers.  This is likely a very significant deviation. The ownership could be changed prior to structuring the parking arrangement, but last-minute changes without time to season the ownership change would significantly increase the risk the transaction could be disallowed as a step transaction under audit.  Deviations from the Private Letter Rulings will significantly increase your risk of structuring this type of advanced 1031 exchange.

You should discuss this more advanced 1031 Exchange structure in greater detail with your legal, tax and financial advisors to determine your comfort level with this complicated 1031 Exchange structure and the inherent risks involved.

Dominic Mazzarella · Answer

As far as I know, a 1031 Exchange doesn’t allow you to use the proceeds for improvements on a property you already own. However, you could look into a “construction exchange” where the funds are used to improve a new property acquired through the exchange, but it must meet specific IRS rules within the time frame.

If I were you, I’d do a little reading on how a construction exchange works and then you’ll probably want to reach out to a qualified real estate attorney. Definitely ask if they have experience with this.

Bill B. · Answer

You can’t already own the property.

Any capital improvements on a not owned yet property would involve a complex 1031 you’d want someone like @Dave Foster involved in.

Jonathan Soto · Answer

i can connect you with my 1031 rep that helped me. send me a message if interested

Ashish Acharya · Answer

@Ethan Borshansky Yes, a 1031 exchange can fund capital improvements, but only on a newly acquired property, not one you already own. Known as an Improvement or Build-to-Suit Exchange, the process requires a Qualified Intermediary (QI) to hold the proceeds, and an Exchange Accommodation Titleholder (EAT) typically oversees the improvements. The replacement property and planned improvements must be identified within 45 days and completed within the 180-day exchange period. The total value (purchase price + improvements) must meet or exceed the relinquished property’s value to defer all taxes. Leftover funds not reinvested are taxable as "boot."This post does not create a CPA-Client relationship. The information contained in this post is not to be relied upon. Readers should seek professional advice.

Can you 1031 Exchange into capital improvements?

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