Internal Revenue Code Section 1031 and Regulations issued by the Internal Revenue Service in 1991 provided investors with a detailed "safe harbor" procedure to exchange real property and defer payment of capital gains taxes. By using an "Improvement Exchange," it is possible for an investor to receive property in a tax-deferred exchange that is renovated or built-to-suit to the investor's specifications. However, as explained below, an Improvement Exchange must be structured and executed carefully to comply with applicable statutory, regulatory and case law.

Requirements for an Improvement Exchange

To achieve the desired tax-deferred treatment, an Improvement Exchange must meet certain requirements. Under the 1991 Regulations, in all tax-deferred exchanges the investor must receive the Replacement Property within 180 days of the date the Relinquished Property is conveyed to the purchaser. The Regulations further provide that, for the value of the improvements to be included in the Exchange Value of the Replacement Property, such improvements must be completed prior to the investor's receipt of such property. For example, prepaying the costs of improvements that will be completed after conveyance of the Replacement Property to the investor is not "completion" under the 1991 Regulations, and such costs cannot be included in the Exchange Value. Therefore, for improvements to be included in the Exchange Value of the Replacement Property, such improvements must be completed and the property conveyed to the investor on or before the 180th day.

Structure of an Improvement Exchange

An Improvement Exchange using a Qualified Intermediary may be structured as follows: The investor and the Qualified Intermediary enter into a comprehensive Exchange Agreement specifying the Qualified Intermediary's obligation to acquire certain property, improve the property to the investor's specifications, and convey the improved property to the investor in exchange for the Relinquished Property. The contract to sell the Relinquished Property is assigned by the investor to the Qualified Intermediary, and the property is sold with the sales proceeds going to the Qualified Intermediary. The Replacement Property and the specific improvements to be made are often identified in the Exchange Agreement, but can be identified up to 45 days after closing.

The contract negotiated by the investor to acquire the identified property is assigned to the Qualified Intermediary, who then purchases and takes title to such property. After acquisition of the identified property, the Qualified Intermediary and the investor cooperate in the construction of the improvements. The investor is responsible for taking the steps necessary to construct the improvements, including retaining the design professionals, contractors, and other persons necessary to complete the project, negotiating all construction contracts, arranging for the construction financing, and supervising the construction. The Qualified Intermediary is a party to the construction contracts, and jointly approves disbursements of the exchange proceeds and other construction funds.

The sources for funding the acquisition and construction costs usually include the exchange proceeds, the proceeds of construction financing from an institutional lender, and/or funds lent by the investor to the Qualified Intermediary. Construction financing is usually made to the Qualified Intermediary on a non-recourse basis and is secured by the Replacement Property. The construction financing may also be guaranteed by the investor if required by the lender.

Upon completion of the improvements (or when the 180-day exchange period is about to expire), the Replacement Property is "sold" by the Qualified Intermediary to the investor at a price equal to the acquisition cost plus the construction cost of the completed improvements. The exchange is completed when the Replacement Property is conveyed to the investor.

Reverse-Improvement Exchanges

On September 15, 2000, the IRS issued safe harbor guidelines for Reverse Exchanges (Rev. Proc. 2000-37) which specify the procedures and conditions under which the IRS will not challenge the exchange because title to the Replacement Property is acquired prior to the conveyance of title to the Relinquished Property. The safe harbor guidelines specifically provide that an investor may supervise the making of improvements to the Replacement Property while it is held by the Qualified Intermediary, and act as a contractor to make such improvements. The Reverse Exchange safe harbor guidelines require that title to the Replacement Property must be conveyed to the investor within 180 calendar days of its acquisition by the Qualified Intermediary.

Although following the safe harbor guidelines will provide comfort to an investor interested in having a Qualified Intermediary acquire a Replacement Property and commence improvements prior to disposition of the Relinquished Property in an exchange, it is also possible to structure these types of transactions outside of the safe harbor limitations. While a non-safe harbor exchange may be open to greater scrutiny by the I.R.S., it does provide greater flexibility to investors whose transactions cannot be completed within the safe harbor time limits or other requirements.

Qualified Intermediary Services for Improvement Exchanges