Improvement Exchange: Step-By-Step Guide
As part of an improvement 1031 exchange, replacement (new) property purchases are structured in accordance with Revenue Procedure 2000-37 whereby exchange funds from the relinquished (old) property sale are used not just to acquire the replacement property at closing but also used to pay for improvements or new construction that are incorporated and made part of the real estate during the 180-Day Exchange Period beginning on the date of the relinquished property closing date. At the end of the exchange when the replacement property is conveyed back to the taxpayer, the value of the improvements is included. This can be helpful in attempting to maximize the tax deferral benefits associated with performing a 1031 exchange.
Revenue Procedure 2000-37 creates a “safe harbor” for this structure and provides that all title, conveyance, and lender loan (if any) documents need to be in the name of a titleholder LLC organized in accordance with specific instructions to be the buyer and borrower for purposes of the purchase. Reverse 1031 CORP. as the sole member of the titleholder LLC acts as the Exchange Accommodation Titleholder (EAT) which steps into the shoes of the taxpayer to accomplish this step.
If the relinquished property is sold first as part of a regular forward exchange, then the subsequent purchase of the replacement property takes place as part of a forward improvement exchange.
If the replacement property purchase takes place first, then the purchase transaction would be called a reverse improvement exchange because the purchase transaction is taking place first in time. The subsequent sale of the relinquished property still must be sold as part of a regular forward exchange with its own separate documentation and fee with a Qualified Intermediary like 1031 CORP. in order to be able to use those proceeds to reimburse the taxpayer for its cash to close plus improvements constructed to date and/or as a pay down of some or all of any mortgage or construction debt encumbering the replacement property.
Whether a reverse or forward improvement exchange, the acquisition of the parked property should be structured with the following considerations:
- As an initial step, it is advisable for the taxpayer and its independent tax/legal/real estate professionals contact Reverse 1031 CORP. as the EAT to discuss the potential transaction, including but not limited to processes, procedures, timing, and costs.
- The taxpayer is free to enter into the contracts for the purchase of the parked replacement property and construction agreements with contractors or materialmen; however, it is important to note that these contracts will need to be assigned to the titleholder LLC as part of the improvement exchange. There needs to be privity of contract between the parties and the titleholder LLC.
- If the closing of the relinquished property takes place before the purchase of the replacement property, the sale take place as part of a regular forward 1031 exchange with 1031 CORP. acting as Qualified Intermediary. 1031 CORP. will coordinate with you and your independent professionals to ensure that you are aware of the technical and chronological requirements.
- When the taxpayer is ready initiate the improvement exchange with Reverse 1031 CORP., the taxpayer will complete an order form and provide a copy of the fully executed purchase contract to the EAT. The EAT will coordinate with all parties about the transaction and prepare most of the required paperwork to structure the purchase as part of an improvement exchange. As part of the improvement exchange document package, the taxpayer in his or her individual capacity may act as a “construction manager” pursuant to a separate Construction Management for purposes of supervising the work and authorizing construction disbursements to be made during the exchange period.
- The purchase of the replacement property will take place in the name of the titleholder LLC. The lender (if any) will send its loan proceeds directly to the title company. All of the lender’s documents, such as the Promissory Note, Deed of Trust/Mortgage, Loan Agreement, etc. are in the name of the titleholder LLC. It is important to note that the taxpayer can personally guaranty the indebtedness without running afoul of the rules. Whether or not there is lender involved, either the Qualified Intermediary, taxpayer or combination of both will send the balance of the net cash to close directly to the title company closer handling the purchase. As soon as the title company closer receives a clear to close, the purchase transaction is consummated.
- The taxpayer then can direct use of exchange proceeds or construction financing from its lender to pay for improvements that are incorporated and made a part of the real estate during the 180-Day Exchange Period which begins running on the first property to close. The payments can be made through disbursement documentation directly to the tradesman, materialman, or taxpayer for reimbursement of pre-paid construction expenses. These expenditures cannot be for prospective services that have not been rendered or personal property/materials that are simply placed property but not yet considered real property under the final regulations (T.D. 9935), published in the Federal Register on December 2, 2020.
- The last step is to convey the improved property from the titleholder LLC back to the taxpayer. One way is for the titleholder LLC to issue a special warranty or quit claim deed back to the taxpayer. The title company handling the initial purchase may have issued a “hold open” policy or CLTA 107.9 endorsement at the closing know that there would be a relatively quick transfer back to the taxpayer to wrap-up the improvement exchange no later than 180 days from the acquisition date. Alternatively, the taxpayer may take an assignment of the membership interest in the titleholder LLC as a way to conclude the improvement exchange. The latter may have the effect of lower transactional costs on the back end by way of reducing or eliminating title/recording fees, transfer taxes, etc. and have the administrative convenience as well as limited liability protections associated with maintaining the LLC as the owner of record. The taxpayer would need to have an amended and restated operating agreement prepared by outside counsel and maintain the LLC in good standing by filing an annual report with the applicable secretary of state. Each state, county, and even city or township has its own rules so it is also worthwhile for the taxpayer’s professionals to advise as to what specifically is applicable in each locality.
Reverse 1031 CORP. recommends that any Taxpayer considering an improvement 1031 exchange should discuss the structure and expense with their independent tax/legal advisors and weigh the tax savings against the transaction costs to see if it is still worthwhile. Improvement 1031 exchanges are not as complicated as they appear with Reverse 1031 CORP. at the helm working with the taxpayer, their advisors and those involved with the transaction in order to simplify the transaction for all parties.
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