An important fact in regard to 1031 exchanges is that you CANNOT make use of your 1031 proceeds to fund improvements on property you already own. This is a common pitfall of unwary investors. In order to qualify for tax deferment, your replacement property must be of like kind with the property it is replacing. Thusly, the property you purchase must constitute real estate with a value greater than or equal to that of the property sold. An improvement that is not completed represents a contract for service, comprising personal property but not real estate. Due to the regulation that a property acquired in a 1031 exchange must be equivalent in type and value with the relinquished property upon closing, it is, at times, difficult to locate one that fulfills these legal requirements and meets his or her specifications.
So, is there a way to the property of your dreams out of a 1031 exchange? There are two main ways you can acquire a build to suit property that measures up to your structural specifications and fulfills the accounting requirements necessary for a like-kind exchange under section 1031
Your first option is to perform what is known as a 'poor man's Build-to-Suit,' in which you ask the seller to make particular renovations on a piece of property in order to heighten its value prior to closing . For example, if you were to relinquish a property worth one hundred thousand dollars, and were looking at a replacement property valued at ten thousand dollars, the seller of the property could construct ninety thousand dollars' worth of improvements in order to raise the value of the piece of property. These completed renovations would constitute real estate. You would then be able to the piece of property for $100,000, complying with the requirement of equivalent value. the majority of sellers, however, will not be eager to perform these renovations so that you may conduct a 1031 exchange.
In the second, likelier scenario a qualified intermediary who is holding your money can buy the replacement property from the seller, taking title to the property in a limited liability company owned by the intermediary. The intermediary would then use the remainder of the money to construct the necessary renovations on the piece of property. Upon completion, the intermediary returns the replacement property to you, allowing you to complete the exchange process.
Back to the ten thousand dollar replacement property: the intermediary would buy the property at the asking price and would construct the desired renovations with the remainder of the funds, transferring the replacement property to you when the property's value is sufficient to establish likeness with the relinquished property.
Although a build-to-suit exchange can go a long towards getting you the replacement property that you really want, it is essential to take into consideration the time required for the construction of necessary improvements. You have only 180 days in which to complete an exchange, so you need to be conscious of what work can actually be completed in this time span. Be mindful that an improvement represents real estate when it is done, so a renovation in progress doesn't increase the property's value. Although you may or may not not be able to modify your replacement property as extensively as you might want, 180 days is plenty of time to finish considerable remodeling, and to bring your replacement property much closer to the property of your dreams.
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