Brandt Nicholson, JD, Principal
In completing an exchange of investment property (or property used in trade or business) under IRC Section 1031, the exchanger occasionally desires to make capital improvements to the replacement property. A question has been raised as a result of the Regulations finalized by the Internal Revenue Service (5/1/91) as to the timing of such improvements relative to the exchanger's taking title to the replacement property.
The Service is presently maintaining a firm position that any such improvements made after the exchanger acquires title do not constitute "like kind" property, and thus may not be added to the value of the replacement property for purposes of the exchange.
It has become common practice for exchangers to have the intermediary "facilitator" hold back part of the equity proceeds from the prior sale of the exchange property, or add additional funds, to effect work on the replacement property after taking title. The work must be completed before expiration of the 180-day replacement period to qualify.
Recall that in order to achieve 100% deferral of gain recognition (i.e., no tax due on sale) the exchanger must acquire replacement property of equal or greater value to the exchange property. Thus, if the exchange property sold for a net of $400,000, the replacement property should be of that or greater value. In this situation, should the exchanger acquire property for less than the target amount, $350,000 for instance, the difference of $50,000 may be made up by qualifying capital improvements.
The practical resolution of the foregoing situation is to close escrow on the replacement property to be improved with title going from the seller to the intermediary. The work of improvement is then initiated and completed prior to expiration of the 180-day replacement period which commenced with close of escrow of the (first) exchange property sale. Title to the thus improved replacement property is then transferred from the intermediary to the exchanger (before expiration of the 180 days).
This procedure, although apparently sound from a tax perspective, raises some practical non-tax considerations, the first of which is obtaining a loan to acquire the replacement property with title in the intermediary rather than the exchanger-borrower. The apparently satisfactory (from the lender's point of view) procedure is for the exchanger-borrower to sign the customary promissory note and the intermediary entity to execute the deed of trust or mortgage securing the note with the replacement property. Some lenders have difficulty with these but are readily resolved.
Other considerations arising from the intermediary temporarily holding title to the replacement property during the period of improvement include insurance, casualty and liability, and general management requirements for the property. These too are readily resolved.
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