What happens when the replacement property in an exchange requires improvements before it is to be used by the taxpayer?

In order to realize the full benefit of section 1031, the purchase price of the replacement property needs to be equal or greater than the sales price of the relinquished property. If a taxpayer’s relinquished property sells for $500,000 and the replacement property is only $200,000, and his basis is $100,000, then the $300,000 of the $400,000 gain will be currently taxed. (Note expenses of sale or purchase which affect the cost and new sales price are being ignored.)

What happens when the replacement property requires improvements before it is to be used by the taxpayer?

Using the same figures as the prior example, the taxpayer finds a replacement property that costs $200,000 but will require $300,000 of improvements. Can this work as an exchange? The answer is yes.

The taxpayer and the QI enter into a typically delayed exchange agreement. The taxpayer’s property is sold and the proceeds go to the QI. The taxpayer designates the $200,000 property “as improved” as the replacement property. The replacement property is purchased by an Accommodation Exchange Title holder (EAT). Paperwork is prepared to reflect that the replacement property will be transferred to the taxpayer when the improvements are completed but in no event later than 180 days from the sale of the relinquished property. Assuming all of the improvements are made during that period, no gain will be recognized by the taxpayer as the sales price of the relinquished property $500,000 will be equal to the value of the replacement property, $200,000 cost plus $300,000 in improvements.

Newport Exchange can put together the paperwork and the mechanics to bring about this arrangement.