This is similar to a construction 1031 exchange (see "Construction 1031 Exchange"), the difference is the new property is not bare land but a "fixer upper" or property where you will construct improvements in an effort to "equalize" your exchange. For example, you sell your old property for $400,000 and you identify a fixer upper for $250,000. You want to add another $250,000 of improvements to it, but only need $150,000 to "equalize" the exchange to the $400,000 target amount to stay away from the capital gains tax. Although the total project cost will run you about $500,000, all you really need is $150,000 of total improvements nailed into the property by day 180. It's important to note you do not need to have all of the $250,000 of improvements made to complete your exchange, you just need $150,000 to equalize and complete it. Therefore, what you do is identify on your 45 day form not only the address of the fixer upper property, but also list the improvements you know you can get done within the 180 day period, such as new kitchen, flooring, appliances, new roof and painting. But here's the catch, whatever improvements you list, they all need to be completed by the 180th day.
Otherwise you run the risk none of the improvements will be included in the exchange. There are specific forms and documents that go into place when doing one of these improvement exchanges, so be sure to call one of our expert exchange consultants to go over the details and fees involved when considering an improvement exchange.
One question we always get is:
If I have a little money left over when I purchase my new 1031 exchange property, can I use that money to add a couple of improvements, such as new appliances, furniture or a new A/C system, rather than have it taxed as "boot" in my exchange? Or do I need to do set up a formal improvement 1031 exchange?
First you need to understand that the day you go in title to your new property is the value the IRS uses for the exchange. In practice, the settlement statement, or HUD 1, will show the date, purchase price and fees you paid for the new property. Therefore, if you just want to add a couple of things into the cost of your exchange to fill up the cash leftover in your exchange and avoid taxable boot, going into a formal improvement exchange is not cost effective. Inexperienced or unscrupulous QI's see these as opportunities to charge extra fees to you because improvement exchanges are complicated exchanges.
When improvements are small and it does not make sense to set up a formal improvement exchange, one way to get around this is to make arrangements with service providers to have the work done right away after closing, and have those costs included on the HUD 1 at closing. The title company will then cut checks directly to those service provider(s) performing that work, and those costs are included on the HUD 1 and your exchange. The title company will then cut checks to you to hold onto to ensure the work gets done. In this manner you can release those checks to the service providers after the work is done. A word of caution though- do not take too long after you go in title to the new property to get that work done and release those checks. Within a week or two after closing is ok, but hanging onto those checks for a few weeks or months after closing will render those costs as boot and taxable in your exchange if the IRS looks into it.
With appliances or furniture, have them charged to your credit card prior to closing and then copy those invoices for the title agent. The title agent will then cut a check to your credit card company and give the check to you to send to them after closing. In this manner those items are paid for from the exchange proceeds and delivery is in process. In addition, by paying by credit card you have guarantees of delivery and performance by the service providers. Should the appliances not get delivered or are in disrepair after install, you can always complain to the credit card company to get reimbursed. Give us a call if you still have questions on how to add small improvements and furniture for your exchange, or if the QI you are working with is requiring you to pay exorbitant fees telling you that you need to get into a formal improvement exchange process with them.