In practice, the requirements to perform an improvement exchange (also referred to as a construction exchange or built-to-suit exchange) are often the most misunderstood. If an investor buys a replacement property for $1 million and, subsequent to closing and acquiring title to the property, builds a $6 million parking garage on the property, does the investor get credit against his 1031 reinvestment requirements for $1 million or $7 million (the $1 million spent on the acquisition plus the $6 million spent on improvements)?

Even the most astute clients would generally reply “seven million,” but the answer is actually $1 million. The reason for this lies in the confusion surrounding what constitutes an improvement exchange entitling the investor to take advantage of the safe harbor provisions of Revenue Procedure 2000-37 and defer gain on the sale of relinquished investment property.

The improvement exchange is commonly utilized to the benefit of real estate investors in the following situations:

• The property to be acquired in the exchange is not of equal or greater value to the property being sold. In that case, the improvement exchange can eliminate a taxable situation by adding capital improvements to an existing property.

• To build a new investment from the ground up. This will maximize the investment opportunity in a given area by enabling investors to build their own properties. The investor doesn’t have to be subject to property currently available for sale, and will not be restricted by the seller’s terms.

• The new investment is of equal or greater value to the property being sold, but it needs refurbishments. Utilize the improvement exchange to refurbish the new property while using tax-deferred dollars.

IRC 1031 does not provide any tax deferral to investors for the cost of improvements made to replacement property after the property has been acquired. The only way to obtain credit for such improvement costs is to either have the seller of the replacement property make the improvements before closing and increase the purchase price to reflect such costs – not an easy or practical feat in today’s marketplace – or to perform a safe harbor improvement exchange under Revenue Procedure 2000-37. To perform a safe harbor improvement exchange, the investor needs to take certain steps prior to acquiring the replacement property and, in many instances, prior to selling the relinquished property.

Under the Revenue Procedure, a parking arrangement must be entered into with a qualified intermediary or an affiliate thereof (referred to as an Exchange Accommodation Titleholder, or EAT, under the Revenue Procedure), pursuant to which the replacement property is parked with the EAT for up to 180 calendar days. This means that the replacement property is transferred by deed from the seller to the EAT, not to the investor.

During the 180-day exchange period, the investor is permitted to make improvements to the property. Documentation including a construction management agreement is entered into between the EAT and the investor. All hard and soft costs expended by the investor during this period that result in improvements to the property, which constitute real property under state law, can be added to the cost of acquiring the real property and reflected against the investor’s 1031 reinvestment requirements. The investor cannot get credit for prepayments to the contractor for improvements not yet completed or for the cost of materials purchased and placed at the site but not yet incorporated into the real estate. Note, however, that the Revenue Procedure does not require that the improvements be completed within the 180-day exchange period or that a certificate of occupancy be issued for the project. The investor is entitled to receive credit for the cost of whatever real property improvements have been made, regardless of the stage of completion of the project.

To ensure than an investor has the maximum 180 days to perform any improvements, the relinquished property should either be transferred simultaneously with the acquisition of the replacement property by the EAT or in close proximity thereto, as any time that elapses between the sale of the relinquished property and the purchase of the replacement property is included in the 180-day exchange period and thus will reduce the period available for improvements. For this reason, many improvement exchanges are structured as reverse improvement exchanges, wherein the replacement property is first parked and the improvements completed and the relinquished property sold during the 180 days following the establishment of such parking arrangements.

Identifying Property

The regulations state the following regarding a replacement property: “A legal description is provided for the underlying land and as much detail is provided regarding construction of the improvements as is practicable at the time identification is made.” This means the investor should identify not only the property being improved but also specify the exact improvements to be made to the property. Often this is accomplished by identifying the parcel of land and providing a copy of the blueprints or construction drawings. The Internal Revenue Service does allow for running construction changes, such as relocating an interior wall by a couple of feet. Nevertheless, it is critical that the property received by the investor is substantially the same as the property identified.

Repair vs. Improvement

Some investors want to know what fix-up costs are considered a repair versus an improvement, because a repair is deductible in the current tax year, whereas an improvement is amortized and depreciated over the life of the property.

The Department of the Treasury distinguishes between repairs and improvements in Reg. 1.162-4: “Â…cost of incidental repairs which neither materially add to the value of the property nor appreciably prolong its life, but keep it in ordinarily efficient operating condition, may be deducted as an expenseÂ…repairs in the nature of the replacements, to the extent that they arrest deterioration and appreciably prolong the life of the property, shall be capitalized and depreciated.”

A repair keeps the property in good operating condition. It does not materially add to the value of the property or substantially prolong its life.

An improvement adds to the value of the property, prolongs its useful life and adapts to new uses.

The key issues to examine are whether the property’s useful life is appreciably prolonged or whether the value of the property has materially increased as a result of the expenditure.