Improvement Exchange: Building on 1031 Replacement Property
An improvement exchange (also called a build-to-suit or construction exchange) lets exchange money pay for building on the replacement property, but only the improvements in place when you take title count as replacement property. An exchange accommodation titleholder (EAT) holds title while the work is done under Rev. Proc. 2000-37, and it has to deed the property to you within 180 days. Anything built after that is a purchase of construction services, which Reg. §1.1031(k)-1(e)(4) says is not like-kind property.
Why you can’t just close and then build
The regulation is the first problem. A transfer of relinquished property “in exchange for services (including production services)” is outside §1031, and any production after you receive the replacement property doesn’t count as receiving like-kind property (Reg. §1.1031(k)-1(e)(4)). If you buy a $300,000 lot with exchange money and then spend $700,000 of your own money building on it, only the $300,000 lot was exchange property.
The case law on land you already hold is the second. Rev. Proc. 2004-51 cites DeCleene v. Commissioner, 115 T.C. 457 (2000), and Bloomington Coca-Cola Bottling Co. v. Commissioner, 189 F.2d 14 (7th Cir. 1951): exchanging real estate you own for improvements on land you also own doesn’t meet §1031. It also cites Rev. Rul. 67-255, which held that a building put up on a taxpayer’s own land isn’t like-kind to that taxpayer’s converted land.
So the building has to go up while someone else owns the property, and you take title once enough of it is built.
How the structure works
The EAT, or a single-member LLC it owns, takes title to the replacement land. Rev. Proc. 2000-37 §4.03 lets you be heavily involved without breaking the arrangement:
- You can supervise the improvements, act as contractor, or manage the property (§4.03(5)).
- You can guarantee the EAT’s construction loan, or lend or advance it money yourself (§4.03(2) and (3)).
- The EAT can lease the property to you (§4.03(4)).
Every QEAA requirement still applies: the written agreement within 5 business days of the EAT taking title, and the property out of the EAT within 180 days (reverse exchange guide has the full table). If you sell the old property first, the ordinary deferred exchange clock also runs from that sale: 45 days to identify, and the earlier of 180 days or your return due date, with extensions, to receive the property (§1031(a)(3)). When both clocks are running, the earlier one controls.
Identifying property that isn’t built yet
Reg. §1.1031(k)-1(e) covers replacement property “to be produced.”
| Issue | Rule | Reg. §1.1031(k)-1 |
|---|---|---|
| Can unbuilt property be identified? | Yes; it doesn’t have to exist when you identify it | (e)(1) |
| Description | Legal description of the land plus as much detail on the construction as is practicable at the time | (e)(2)(i) |
| Value for the 200% rule | Estimated fair market value as of the date you expect to receive it | (e)(2)(ii) |
| Design changes | Usual or typical production changes are ignored; substantial changes mean you didn’t receive substantially the same property | (e)(3)(i) |
| Unfinished at transfer | Counts as substantially the same only if the finished version would have, and only to the extent it is real property under local law when you receive it | (e)(3)(iii) |
| Work after you take title | Not like-kind property | (e)(4) |
The regulation’s own example has a taxpayer receive property on the last day of the exchange period with construction 20% complete. The land and that 20% count. The other 80%, finished later, does not.
Worked example: what it takes to defer all the gain
Round numbers, for illustration only, ignoring closing costs.
You sell a building for $1,000,000. Your adjusted basis is $500,000, so the realized gain is $500,000. At closing, $400,000 pays off the mortgage and the QI holds $600,000.
To defer all of it, the property the EAT deeds you has to be worth at least $1,000,000, all $600,000 of exchange cash has to go into it (so you receive no cash), and you have to take on at least $400,000 of debt or add your own cash. That last part comes from §1031(d): debt you’re relieved of counts as money received. The Form 8824 instructions (line 15) net it against debt you assume and cash you pay.
The plan: the EAT buys a lot for $300,000 and builds $700,000 of improvements. The $600,000 of exchange money plus a $400,000 construction loan to the EAT, which you guarantee, pays for it.
| Case A: all built by day 180 | Case B: $500,000 built by day 180 | |
|---|---|---|
| Land | $300,000 | $300,000 |
| Improvements in place at transfer | $700,000 | $500,000 |
| Value you receive | $1,000,000 | $800,000 |
| Exchange cash used | $600,000 | $600,000 |
| Loan drawn and assumed by you | $400,000 | $200,000 |
| Debt relieved on the old property | $400,000 | $400,000 |
| Net debt relief (boot) | $0 | $200,000 |
| Gain recognized (lesser of gain or boot, §1031(b)) | $0 | $200,000 |
| Gain deferred | $500,000 | $300,000 |
In Case B the last $200,000 of construction, paid for after you take title, is ordinary building cost added to your basis. It isn’t exchange property. Putting more cash in at the transfer wouldn’t fix it, because the property you’re receiving is only worth $800,000 against the $1,000,000 you gave up.
The builder’s schedule has to be set against the transfer date, because the value that counts is whatever is physically in place that day. Our boot guide explains how the recognized $200,000 is taxed, and the capital gains calculator runs the numbers.
Building on land you or a relative already own
Rev. Proc. 2004-51 makes the safe harbor unavailable for replacement property you owned at any time in the 180 days before the EAT took title. Combined with DeCleene, you can’t deed your own lot to an EAT, have it build, and take the lot back as replacement property.
A related variation, where a person related to you leases land to the accommodation party, the accommodation party improves it, and then transfers the leasehold with improvements to you, is one the IRS said in 2004 it was “continuing to study” (Rev. Proc. 2004-51 §2.06). There’s no safe harbor for it. Anyone considering that structure needs a tax attorney’s opinion; related-party rules also apply (related party guide).
Confirm the construction schedule, the identification language and the loan structure with your CPA or tax attorney before the EAT closes on the land. Ask any QI you interview how many improvement exchanges it has run. If the construction needs a loan, Janover Capital can look at the financing.
Sources
Questions people ask
Do improvements built after I take title count toward the exchange?
No. Under Reg. §1.1031(k)-1(e)(4), production that happens after you receive the replacement property is not treated as receiving like-kind property. Only what is in place, and is real property under local law, when you take title counts.
Can I build on land I already own as part of an exchange?
Not under the safe harbor. Rev. Proc. 2004-51 bars replacement property you owned in the 180 days before the titleholder took title, and it cites DeCleene v. Commissioner for the rule that improvements on your own land are not like-kind to real estate you give up.
How do I identify a building that doesn't exist yet?
Give a legal description of the land and as much detail about the planned construction as is practicable when you identify it. For the 200% rule you use the property's estimated value as of the date you expect to receive it.