1031 exchange funds used for capital improvements?

Question

I'm going to be doing a 1031 exchange on a property I own and I was curious if it is possible to use some of the funds to do capital improvements on the property(s). So say I purchased 3 homes which I understand is the maximum(?), would it be possible to use the remaining funds to perform capital improvements, and is there a maximum dollar amount limitation on this before it's considered "boot"?

Dave Foster · Answer

@Chris Wampler, The rules of 1031 will not allow you to use exchange funds on properties you already own.  So if you purchase a value add with your exchange you can't subsequently use exchange funds to improve.

But, if the numbers work you can use a process called a reverse exchange, or more specifically an improvement exchange.  They're more complex and costly but can be a great way to include improvements from your exchange proceeds.  In a reverse exchange the 1031 QI forms a stand alone LLC and takes title to your new property in that LLC apart from you.  If you're old property has closed then exchange proceeds can be used to purchase it.  If not you must provide the funds from reserves or a loan.  Then the property is improved (you're the one doing the improvements even though the QI is on title).  Once the improvements are complete then title is transfered to you at the new value of acquisition cost + the cost of improvements.

Example - Sell a property for $300K.  IN a reverse improvement exchange purchase a property for $250K then put $50K in improvements.  Now the replacement property is worth $300K.  So you sold for $300 and subsequently bought for $300 (from the QI) and you have completed a successful 1031 exchange.  The reverse portion is really a second process added to a regular 1031.

Regarding identification -

You can purchase as many replacements as you want.  The restrictions are on the identification and valuation (i know that's strange).

Remember you have 45 days to identify your potential purchases after you close your sale.  so during that period you can close on properties go into contract for properties or just identify properties.  But after midnight on day 45 there must be a list in writing in place and here's the parameters.

1. If you name 3 or fewer properties then they can be worth anything - sell a property for $100K and name three $5 million properties.

2. If you want to name more than 3 properties then the aggregate value of the list can't be more than $200% of what you sold.  So if you sold a property for $200K you could name 4 or 40 properties but their total value couldn't be more than $400K

3.  Unless (and we're henceforth naming this the @Mark Creason rule)... you actually close on 95% of the list.  so if you sold for $200K and named more than 4 properties but their total value was $500K you could still complete a successful exchange as long as you purchased at least $475K of your list.  This ones pretty difficult to do unless you're closing on all the properties during the 45 day period when you can shape the list to simply be what you already closed on.

Dave Foster · Answer

@Chris Wampler, the EAT (exchange accommodating title holder) is literally the LLC formed to hold the property in the reverse exchange.  The QI forms the EAT (which is owned by the QI) and purchases the property you want to eventually own.

The purchase is usually (but doesn't have to be) funded by a combination of a down payment from you and a bank loan made to the EAT but secured by you.  Conventional lenders will not do reverse lending but portfolio lenders like private lenders and community banks that invest locally and hold their own notes have no problem with these at all.

Once the EAT has title to the new property it can hold it for up to 180 days while you finish selling your old property.  The EAT owns the new property.  You own the old property.  So you can still sell your old property and buy the new property in a regular 1031 exchange.  Your just buying it from a friendly party (the EAT).

It all completes when you sell your old property and buy the new property (or take the membership interest in the EAT which qualifies and avoids a double real estate closing).  You are paid back your down payment.  The bank is paid off or paid down and you assume the rest of the loan, and voila' you get title to the new property (or the LLC that owned the property).

These were done for decades (boring but crazy fact - they used to be called Rutherford Exchanges and the original case if I remember was the sale of some pregnant cows with payment being their offspring when born).  In Rev Proc 2000-37 a safe harbor reverse exchange was codified.

I've got another 10,000 ft analysis of the reverse I'll send you to see if that clears things up.  Forum posts, are tough to flesh things out too much in.

Dave Foster · Answer

@Chris Wampler, You got it!  The EAT (Exchange Accommodating Titleholder) is the statutory name of the entity that the QI sets up.

And yes, that's another benefit of setting up the reverse correctly - The use of a single member single asset LLC allows us to transfer the membership of the LLC to the client instead of having to conduct another real estate closing.

So the EAT would be an LLC that is holding the property after it's been completed and to finish your 1031 exchange you get the membership interest of the EAT that holds the property.  So you get a free LLC and no real estate closing costs which can mitigate some of the cost of the improvement exchange.

Another thing that's not thought of often but while the EAT owns the property you are in control and getting all benefit of appreciation and cash flow (if any) while at the same time you still own your old property so you continue to reap the benefits of owning that property - appreciation, cash flow, deductions, etc).

Mark Creason · Answer

@Chris Wampler

You have other options besides buying 3 properties maximum.  You can ID using the 200% rule and I believe there is a third option.  @Dave Foster can probably describe better.

Mark

Wayne Brooks · Answer

Yes, @Dave Foster will know the specifics.

Chris W. · Answer

I take it that you also perform EAT's as well? I reviewed the white paper that you sent me and the fees. Still waiting on the guy in Hawaii to send me his schedule. What's the cost difference 1031 exchange vs. EAT and is it also an alternative to set the LLC up for the property on the back end of the 1031 exchange with no added hassles/hurdles? Does the EAT "buy" the property prior to the original unit being sold? Seems like some may balk at the concept of this. I suppose I'm confused how the EAT essentially takes possession of the new property, while at the same time the original property is still there and you can receive income from both. Or is it that both are being swapped under the LLC formed. Also does one have to get complete financing on the new property, or how does that work? If you could, what's the IRS code reference? I might just read the whole shebang to make sure I've analyzed the facets properly.

Chris W. · Answer

Once again @Dave Foster with the big answer win! Sounds good, is the reverse exchange akin to an EAT or an entirely different animal?

The Improvement exchange sounds appealing to an extent as it accomplishes the goal of the property being in an LLC, but can you buy the LLC itself with the asset? Like $300K property after the renovation of $50K, can you buy the LLC separate from me with property in it for $300? Or am I understanding that incorrectly and the LLC is solely for a holding entity?

Chris

Bob E. · Answer

@Dave Foster  Dave, that was very insightful.  Thank you for sharing your knowledge.

1031 exchange funds used for capital improvements?

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