Is there any way to add rehab costs into a property I plan to buy for 1031 exchange?

Question

When doing a 1031 Exchange, is there any way that I can purchase a property that needs fixing up and have the actual property acquisition price plus the rehab price considered when doing the Exchange?

I have a house that I purchased approx 3 years ago  for about $130,000 that is currently being rented but the tenants are moving out soon.  I find that the ROI on that property is not nearly as much as if I purchased a property very cheaply (under $50,000) and rehab it, putting $10-$30,000 into it, depending on its needs, so it is an medium to upper scale rental.

Is there any way to do this within a 1031 Exchange or am I just going to have to purchase 2 cheaper properties and use my own money to rehab them?

Any input would be appreciated

Rob Beland · Answer

Short answer is sort of @Sandy Uhlmann. If you want to sell your first property and 1031 into a new property, the new property must be of equal or greater value than the first. If you find two less expensive properties they can be combined to create enough value. The rehab costs can be rolled into the new properties basis by way of a Rehab Exchange. It requires the QI to hold the rehab funds in escrow and I believe you have 6 months to complete the rehab. The key is that the property can not then be flipped. It must be held for investment for at least two years. Rehab/flip projects do not qualify for a 1031 exchange.

Dave Foster · Answer

There are a couple of ways to do what you suggest @Sandy Uhlmann.  But what has been described so far will not work unfortunately without  a great deal of expense and added effort.  What @Rob Beland is describing as a rehab or improvement or type of reverse exchange.  In every exchange without exception you may not take title to real estate and then improve it from the proceeds of your sale.  Once you take title to the real estate your exchange is done.  In order for what Rob describes to work your QI has to take title to the new real estate first and then complete the improvements using proceeds from your exchange account so you can then take title to the entire thing post - improvements.  That adds a level of expense that is probably prohibitive in the 50K property realm.

Two other potential solutions

`1. Negotiate with the seller for a higher price to include the improvements.  That ones easy logistically but they have to be willing and able to perform the improvements and you have to verify that they will be done to your standards.

2. If the amount of improvements is less than 15% of the purchase price of the new property then it falls into a vague category that the IRS calls "deminimus".  Property that normally accompanies real estate (like a garage or roof or sidewalk etc) but is minimal as a % of the entire purchase.  We have a number of clients that will use this interpretation to fund improvements  at the closing of the purchase.  First the amount must be less than 15% of the purchase price - in a $50K house that would be $7500.  Second you identify the vendor and the exact amount for the repair (let's say is Joe the Roofer and the amount is $5000).  Third, the closer is instructed to place a concession item on the settlement statement of $5000 payable to Joe the Roofer.  After the close and when you verify that the work has been done Joe the Roofer gets his check from the title company.  You did not touch any of the money so your exchange is intact and your new property now has a new roof.

Rob Beland · Answer

Just so Im on the same page @Dave Foster my comment was based on the assumption that the newly acquired "rehab property" would be acquired for $X ($130K in value/basis needed to complete the exchange). $100K base purchase price deeded to QI + $30K in rehab money put into the deal by @Sandy Uhlmann. Rehab completed and 1031 completed within 180 day limit. QI would have disbursed the funds to the contractors upon completion of improvements.

Would this scenario work to complete the 1031 and defer the capital gains?

Dave Foster · Answer

Yes @Rob Beland.  I think what you're saying is that the sale of the old property was for 130K and the new property purchase price was 100K. The QI takes title using 100K of the exchange proceeds and then spends the remaining 30K on improvements again using the exchange proceeds and when that is done within the 180 days from closing of the old property the deed is transferred to the client so she sold for $130 and bought for $130.  That would work.

These types of reverse exchanges can cost several thousand dollars which is why the simpler approach of just a regular exchange and some deminimus repair concessions may be a better fit.  In the example above the amount was far above any deminimus level so a reverse exchange would be the way to go.  But the calculation to make in that instance is that the cost savings on a partial exchange with 30K in boot may be less than the cost to do a reverse/improvement exchange.

@Sandy Uhlmann - you'll find the cost of exchanges to be highly regional and usually based on volume and attorney specific involvement.  Most national QI firms will charge 750 - 1000 for a garden variety exchange.  They should consult with you to make sure the fit is right and you understand the rules.  They will document the 1031 with the appropriate closing entity, and they hold the proceeds until you are ready to purchase the new property.  Good QI's will walk with you through the process especially if you're new to the process.  Once you've done one a lot of the fear and uncertainty go away.

Wayne Brooks · Answer

@Rob Beland To clarify, the rehab improvements must be completed, and paid for, within the same 180 day clock that applies for the replacement property, so you need to buy And rehab within the 180 days.

Sandy Uhlmann · Answer

What is the typical cost of doing an exchange?  Is it all paid to the QI?  Does the QI do all the paperwork or just hold the funds in escrow?

Rob Beland · Answer

That is correct @Wayne Brooks. I did just look up and confirm that. And as far as 1031s go, there are no exceptions and no provisions in the IRS code to extend the 180 days you have to complete the 1031 exchange regardless of whether or not there is rehab involved.

Is there any way to add rehab costs into a property I plan to buy for 1031 exchange?

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