A real estate exchange is about giving up business or investment real estate and replacing (exchanging) it with new business or investment real estate. Any improvements have to be part of the initial purchase to be considered real estate. Once you own the replacement real estate you can not add more exchange money to the real estate you already own. The QI, settlement company or Attorney can’t hold back or release any 1031 escrow cash to buy improvements (e.g., a roof or a kitchen) because improvements aren’t real estate – they are personal property (shingles, cabinets, etc.) until they are installed. The improvements must be installed before you take ownership for them to be considered real estate and included in the exchange.
There are two primary options to accomplish this:
- Ask the seller to improve the property before you take ownership, which obviously requires a cooperative seller. We have seen some creative contracts structured to cover this situation wherein you promise to buy the seller’s property with completed improvements if you can select the contractor, manage the installation, etc. These requirements would be outlined in the contract to purchase. You can provide earnest money deposits to the seller, as part of the contract offer, so the seller has the money to complete the improvements before you take title to the property. The risk is advancing money to the seller before you take ownership.
- Do an improvement exchange. An improvement exchange uses the IRS reverse exchange provisions which allow us to create a holding company, called an Exchange Accommodation Titleholder (EAT), to temporarily hold the title (ownership) and complete the improvements before you take title. Reverse exchanges are more complicated. They involve another set of settlements, risk for the EAT, funding issues, etc. and are therefore more expensive; we typically charge $5,000 or more to coordinate as an EAT, so your tax savings for incorporating the improvements would really need to be worth the additional expense.