Advanced Improvement 1031 Exchange Strategies: Improvements on Property Owned by a Related Party
A 1031 Exchange allows real estate investors to defer capital gains taxes by reinvesting in like-kind property. While the rules may seem straightforward at first glance, more advanced strategies—such as using exchange funds to make improvements—require a deeper understanding of IRS guidelines. The rules become even more complex when improvements are planned on property owned by a related party.
This article explores the IRS framework governing these transactions and key considerations investors should keep in mind.
The Basics of an Improvement Exchange
In a standard 1031 Exchange, an investor sells a relinquished property and acquires a replacement property of equal or greater value. In an Improvement (or Construction) Exchange, exchange funds can be used to build or renovate a property, provided that:
The improvements are made before the investor takes title, and
The value of the replacement property (including improvements) meets or exceeds the relinquished property’s value and equity.
This structure requires a Qualified Intermediary (QI) and often an Exchange Accommodation Titleholder (EAT), who holds the property during construction to ensure compliance with IRS safe harbor rules.
Related Party Rules in 1031 Exchanges
The IRS places strict limits on exchanges involving related parties, defined under Internal Revenue Code Sections 267(b) and 707(b). Related parties include:
Family members (spouse, siblings, parents, children, etc.),
Entities where the investor has significant ownership, and
Partnerships, corporations, or trusts with overlapping control or interests.
The IRS is concerned that related party transactions could be used to shift tax liability or cash out tax-free. For this reason, exchanges involving related parties are closely scrutinized, and additional restrictions apply.
Improvements on Related Party Property
The question often arises: Can an investor use exchange funds to improve property that is owned by a related party?
Here’s what the IRS guidance and case law make clear:
Direct acquisition of related party property is generally not allowed.
If the investor purchases replacement property from a related party, the IRS may disallow the exchange unless both parties hold their properties for at least two years.
Using exchange funds for improvements on related party property is problematic.
Even if the related party retains ownership, the IRS typically views improvements on property owned by a related party as a form of indirect acquisition.
The reasoning: The investor is using tax-deferred funds to enhance an asset that benefits a related party, not to acquire a qualifying replacement property.
IRS rulings have consistently disallowed these types of transactions.
In Private Letter Rulings (PLRs) and published guidance, the IRS has held that improvements on related party property do not qualify for 1031 treatment, as the investor never receives ownership of the improved real estate during the exchange period.
Why Timing and Ownership Matter
For improvements to qualify in a 1031 Exchange:
The property must be held by the EAT (not the related party) during construction.
Title must ultimately pass to the exchanger as the replacement property.
Improvements completed after the exchanger takes title generally do not count toward the exchange requirements.
If the related party continues to hold the property during or after the improvements, the IRS is likely to disallow the transaction.
Practical Takeaways for Investors
Direct ownership is essential. Exchange funds must be invested in property the exchanger will ultimately own, not property owned by a related party.
Plan early. Advanced strategies such as improvement exchanges require careful structuring before the sale of the relinquished property.
Understand the two-year rule. If a related party is involved, both parties generally must hold their properties for two years to maintain tax deferral.
Work with qualified advisors. These transactions involve complex tax rules and require coordination with experienced tax and legal professionals.
Improvement exchanges can be a powerful tool for maximizing the benefits of a 1031 Exchange, but using funds to improve property owned by a related party is not a viable strategy under current IRS guidance. To ensure compliance and preserve tax deferral, investors should focus on improvement projects where they will directly acquire ownership of the replacement property.
