Construction 1031 exchange is quite popular because of the tax deferral it offers. It is also known as Improvement or Built-to-Suit 1031 Exchange. With this strategy, you cannot just swap your old property with a new one. In fact, you can also use some of the sale proceeds (exchange funds) to improve the newly acquired replacement property.
You may be wondering: how to use this strategy? And how does it benefit you? Well, we have covered all the answers you seek. This blog is a go-to guide for real estate investors. Keep reading to enhance your knowledge about Construction 1031.
What is Construction 1031 Exchange?
A Construction 1031 exchange is a real estate strategy based on Section 1031 of the U.S. Internal Revenue Code. With its help, you can make tax-deferred property reinvestments. In other words, this tactic lets you save on capital gain taxes and maximizes your return.
But this is not all it does! In fact, it allows investors to use some of the amounts from the sale proceeds for the improvements or new building construction of the acquired investment property aka (replacement property). This is the reason why this strategy is known as construction or improvement 1031 exchange.
“A Construction 1031 helps investors create the perfect investment property they envision to acquire.” – Equity Advantage
Moreover, this strategy opens a range of opportunities for real estate investors. After all, they can build the property they seek using this strategy. Besides, they don’t even have to spend a huge amount of money on the improvements. Because much is covered by the exchange funds of the previous relinquished property.
You should know that this strategy allows you to follow certain rules and timelines that the IRS has said. Failing to do so can lead to ineligibility for the 1031 exchange. Some of the major rules are:
- Like-kind properties for the exchange
- Properties for investment or business only
- 45-day deadline for identifying properties
- 180-day deadline for completing the exchange
We know the basics and the major rules of this strategy. Hence, it’s time to talk about how a construction 1031 exchange works.
How Does a Construction 1031 Exchange Work?
As aforementioned, a construction 1031 allows you to make necessary changes or improvements to the new investment property. But how does it actually work? If you are new to the world of real estate investment, navigating through the nuances of property exchanges can be overwhelming. Therefore, always hire a real estate advisor for expert guidance and well-rounded assistance. Anyway, here is how a construction 1031 exchange works:
What Happens During the Sale of Relinquished Property?
The process of construction 1031 begins with the sale of the relinquished property. Moreover, this is a great way to maximize your investment potential. After all, it lets you swap your less profitable property with a more profitable one. Moreover, you have to structure this exchange as a 1031 from the beginning to avail of tax benefits. Besides, you have to transfer all the sale proceeds to the Qualified Intermediary (QI) immediately after the sale, instead of keeping it to yourself.
How Do You Identify and Purchase Replacement Properties?
Identification and Purchase
The Internal Revenue Service has set very strict deadlines to carry out different stages of your construction 1031 exchange. Moreover, the investor has to identify the replacement properties within 45 days of selling the previous one. Apart from this, you have 180 days for the completion of the whole process.
This means the investor has to sell the relinquished property, identify the replacement ones, and purchase them within the time span of 180 days. Failing to do so will result in disqualification.
Therefore, following these deadlines is mandatory.
How Do You Complete the Exchange?
Completion of the Exchange
After the construction or improvements, the next step is to acquire the new – replacement – property. As you already know, you have to do it all within the 180-day limit. Moreover, the QI has to transfer the money to the seller to complete the transaction.
After that, you are free to acquire the property. The best part about the construction 1031 exchange is the tax deferrals it comes with. Also, you have to make sure that you are investing in a like-kind property. After all, others don’t qualify for the exchange.
Moreover, such kinds of exchanges are complex to deal with on your own. Therefore, working with a qualified intermediary or an advisor is important. They can help you with everything from documentation to free evaluation of your relinquished property. They also help investors thoroughly abide by the rules and regulations of the IRS.
How a Construction 1031 Exchange Works with Other Strategies?
You should know that construction exchanges are often combined with either a forward or a reverse 1031 exchange. Moreover, these combined strategies are quite beneficial but equally complex. Anyways, let’s get into how they work:
What Is the Relationship Between Construction 1031 & Forward 1031?
You can structure your property reinvestment as a forward 1031 exchange to take advantage of construction 1031. If you don’t know a forward 1031 exchange involves the sale of existing property first and then the purchase of replacement property. Moreover, the forward strategy allows you to get started with the construction work before the actual closing of the transaction. Resultingly, you are able to build your desired investment. Furthermore, customizing your investments based on your goals and needs can be a very beneficial move.
How Construction 1031 Works with a Reverse 1031?
You should know that a reverse 1031 is a strategy with which you can purchase the replacement property first and then sell the relinquished one. You may be wondering how it works with construction exchange. Well, it allows you to begin the improvements while you are looking for sellers for your existing property. This can be a more efficient approach as it allows you to multitask: start the improvements while looking for a seller.
Now that you have two options, the choice is yours. You can go for the one that is more convenient based on your needs and goals.
How Much a Construction 1031 Exchange Cost?
Costs or Fees for a Construction 1031
The cost is higher and more complex as compared to the regular 1031 exchange. Why so? Because they include the cost of construction or improvement along with the exchange fees. Besides, make sure the overall price you have to pay for these real estate exchanges is justified. For this, you also have to consider factors like:
- Amount of Depreciation
- Recapture Deferrals on Income
Tax Liabilities Whether or not to go for a 1031 exchange depends on its total cost. Higher costs means that you should not choose it for your reinvestment. Moreover, you should always consult a real estate advisor to make the right decision. Otherwise, you may end up making the wrong choice.
Conclusion
Construction 1031 exchange is a legal strategy that allows you to save big on taxes. The best thing about it is that it gives you a chance to build your ideal investment property. After all, you can use some proceeds from your sold-out property for the improvement or construction in your replacement property. The IRS abides you to follow a strict procedure if you are doing this exchange. Moreover, you can combine this strategy with a forward or reverse 1031 for a more streamlined process and increased profits.
