As we mentioned previously, when it comes to deferring capital gains tax through a 1031 exchange, not only is it imperative that the sale closes before the purchase, but, you also need to purchase a property that is of equal or greater value than the sale.
In an improvement exchange, the Exchangor has found a replacement property that is less than the value of the relinquished property, but with some necessary improvements and a little elbow grease, the value of the property could be increased to a value that meets the Exchangor’s 1031 exchange requirements.
THE PROCESS
The improvement exchange is set up similar to the reverse exchange with the variation where the replacement property is “parked”. In this scenario, the Exchanger has SCES form an LLC to become the Exchange Accommodator Titleholder (“EAT”) for the replacement property that needs to be improved. Exchangor loans funds to the EAT to purchase and “park” legal title to the replacement property. The EAT leases the property to the Exchangor under a NNN lease and Management Agreement.
During ownership of the EAT, Exchangor secures a licensed and bonded contractor, who is also added as an additional insured under the Homeowners Insurance Policy set up by Exchangor. The contractor and Exchangor agree upon needed improvements to the replacement property. Payments to contractor or any other person conducting business on said property, are to be handled through the EAT, but funds are provided by the Exchangor.
If Exchangor needs to borrow funds from a third-party lender in order for the EAT to acquire the replacement property or make the improvements to the replacement property, the non-recourse loan needs to be in the name of the EAT but guaranteed by Exchangor. Not all lenders provide this type of service or product. Working with SCES ensures you will work with reputable lenders who understand and are experienced with these specific transactions.
Once all improvements are completed, the new replacement property will need to be appraised. Hopefully the appraised value is equal to or greater than the value of the relinquished property. Exchangor may now sell the relinquished property like they normally would in a delayed exchange. Exchangor enters into an Exchange Agreement, outlining SCES’s role as a qualified intermediary, and Exchangor assigning its rights over to SCES, which allows SCES to receive the funds from the sale.
Exchangor uses the proceeds held with SCES to purchase the newly renovated replacement property from the EAT. During this transaction, the funds from the sale will be used to repay the Exchangor for the monies it loaned the EAT to purchase the replacement property on their behalf. If Exchangor used a third-party lender to fund the transaction, additional proceeds from the sale will be used to pay that loan off or down. Title is then transferred by direct deed from the EAT to Exchangor.
ANOTHER IMPROVEMENT EXCHANGE VARIATION
As we mentioned above, Improvement exchanges are most often “parking” the replacement property with the EAT before they sell the relinquished property. An Exchanger will likely use this variation if they found the fixer-upper replacement property before they are ready to sell the relinquished property.
If the Exchanger is in contract with a Buyer on their sale property and they prefer to use those exchange proceeds to purchase the fixer-upper replacement property, they may want to use this other variation. In this scenario, the Exchanger enters into a Delayed Exchange where Exchanger uses SCES as its qualified intermediary who will assign itself into the transaction to receive funds from the buyer when the sale closes.
Exchangor will have to properly identify the replacement property within the 45-day Identification Period and be very specific about the improvements being made. In order for the Exchangor to defer all of their capital gains tax, they must meet three basic requirements: 1) spend all the exchange funds on the completed improvements or down payment by the 180th day; 2) receive the same property properly identified or one that is substantially close to it, by the 45th day; and 3) the replacement property needs to be of equal or greater value than the sale property when its finally deeded back to Exchanger.
Exchanger will have SCES form an LLC to act as the EAT for the replacement property. Exchangor can use the exchange proceeds from the sale and loan them to the EAT, through a Promissory Note, to purchase the replacement property from the Seller. During the EAT’s ownership, Exchanger will hire a licensed and bonded building contractor specified in the NNN lease and Management Agreement Exchanger signed with the EAT. The contractor will make the necessary improvements to the property, agreed upon by Exchangor.
All improvements need to be done within the 180-day Exchange Period. Once improvements are complete, the property needs to be appraised. The final value of the newly renovated replacement property is the combination of the original purchase price plus the capital improvements made to the property. And, all improvements must be made prior to the EAT transferring title to Exchanger.
One thing to consider with this variation is that all improvements are limited to the 180-day Exchange Period. This timeframe can be limiting if substantial improvements are being made to the property and weather permitting can be a factor.