Advanced Strategies: Reverse and Improvement (Build-to-Suit) Exchanges

April 16, 2024
1031 National Services

In a typical 1031 exchange, you sell one property (the “relinquished property”) in order to buy another (the “replacement property”). But what if you identify the ideal replacement property before you can sell the property you will be relinquishing? Or, what if you want to use some of the proceeds from the sale of your relinquished property to renovate your new asset? Both of these are possibilities with the help of a facilitator who provides advanced 1031 exchange services.

Each of these types of 1031 exchanges has its own name and its own unique set of rules and requirements. Buying a replacement property before selling a relinquished property is called a reverse 1031 exchange, while using a portion of the sale proceeds for renovations is called an improvement (or build-to-suit) 1031 exchange.

Let’s look at each of these advanced 1031 exchange strategies in detail:

Reverse 1031 Exchanges

We’ll cover reverse 1031 exchanges first. A reverse exchange is an advanced strategy that allows property owners to take advantage of the beneficial tax treatment afforded by Section 1031 of the Internal Revenue Code without meeting the strict timing requirements for a traditional or “pure,” like-kind exchange.

How Does it Work?

The Internal Revenue Service (IRS) recognized the validity of reverse 1031 exchanges in Revenue Procedure 2000-37. Provided that taxpayers executing these exchanges meet certain requirements, they can secure the tax benefits of conducting a like-kind exchange in reverse—acquiring their replacement property before selling their relinquished property.

To conduct a reverse 1031 exchange, it is necessary to work with an Exchange Accommodation Titleholder (EAT). The EAT enters into a Qualified Exchange Accommodation Agreement (QEAA) with the taxpayer and takes title to the replacement property. At this point, since the EAT is the title owner of one of the replacement property—and since the EAT is bound by the QEAA—the taxpayer can work on finding a buyer for the relinquished property (or deciding which asset to designate as the relinquished property) without worrying about losing out on the opportunity to acquire the highly desired replacement property.

Alternatively, the EAT can take title to the relinquished property, and then the taxpayer can purchase the replacement property directly.

What Are the Benefits?

The benefits of conducting a reverse 1031 exchange are the same as those of a pure 1031 exchange in terms of indefinite tax deferral, but the taxpayer gets the additional benefit of not being time-limited with regard to finding a replacement property. Additionally, if prices are expected to rise, taxpayers can use reverse 1031 exchanges to buy before prices go up and then sell afterward. As noted above, taxpayers can also use reverse 1031 exchanges when they want to wait to decide which property to sell until after they decide which new property to buy.

Improvement (Build-to-Suit) 1031 Exchanges

An improvement (or build-to-suit) exchange is another type of advanced strategy that leverages the tax deferral benefits afforded by Section 1031. When used properly, an improvement 1031 exchange allows the taxpayer to avoid triggering tax liability on what might otherwise be classified as boot.

How Does it Work?

In a pure 1031 exchange, any proceeds from the sale of a relinquished property that are not used when acquiring a replacement property will generally be considered boot, which is taxable under Section 1031. However, it is possible to avoid this unfavorable tax treatment by using excess proceeds to improve the replacement property.

Conducting an improvement (or build-to-suit) 1031 exchange also typically involves working with an EAT—and the fundamentals behind an improvement exchange are similar to those behind a reverse exchange. Since the EAT takes title to the relinquished property (or, in some cases, the replacement property), the strict timelines that govern pure 1031 exchanges aren’t an issue. However, the other formalities involved in conducting an exchange must still be observed, and this means that it is advisable to work with an experienced advanced 1031 exchange services provider.

What Are the Benefits?

The benefits of conducting an improvement (build-to-suit) 1031 exchange are similar to those discussed above for reverse exchanges—and improvement exchanges can be combined with reverse exchanges when it makes sense to do so. Conducting an improvement exchange also provides the added benefit of avoiding tax on proceeds that would be classified as boot in a pure 1031 exchange.

Schedule a Free Consultation About Our Advanced 1031 Exchange Services

If you have questions about conducting a reverse 1031 exchange or an improvement (build-to-suit) 1031 exchange, we invite you to get in touch. Call 888-872-1031 or contact us online to schedule a free consultation about our advanced 1031 exchange services.