Understanding Improvement 1031 Exchanges (Build-to-Suit or Construction Exchanges)

A traditional 1031 Exchange allows real estate investors to sell an investment property and reinvest the proceeds into a “like-kind” replacement property while deferring capital gains taxes. But what if the replacement property doesn’t quite fit your needs as-is?

That’s where an Improvement 1031 Exchange (also called a Build-to-Suit Exchange or Construction Exchange) comes in. This strategy not only lets you acquire a replacement property but also use exchange funds to make improvements — all while maintaining tax deferral.

What Is an Improvement 1031 Exchange?

An Improvement Exchange gives investors more flexibility than a standard 1031 by allowing them to:

• Sell a relinquished property.

• Acquire a replacement property.

• Use exchange proceeds to fund improvements, renovations, or new construction on that replacement property.

As long as the transaction is properly structured, both the purchase price and the improvement costs qualify for tax-deferred treatment under Section 1031.

This makes the strategy especially useful when:

• The ideal property isn’t available in “move-in ready” condition.

• An investor wants to add value through upgrades.

• A development opportunity better aligns with long-term investment goals.

Forward vs. Reverse Improvement Exchanges

Improvement Exchanges can be combined with either a Forward 1031 Exchange or a Reverse 1031 Exchange.

1. Improvement + Forward Exchange

• The relinquished property is sold first.

• Proceeds are used to acquire the replacement property and fund improvements.

• Both the acquisition and improvements must be completed within IRS deadlines (45 days for identification, 180 days for completion).

2. Improvement + Reverse Exchange

• The replacement property is acquired first (through a parking arrangement).

• Improvements are made while the investor works to sell the relinquished property.

• At closing, the improved property is transferred to the investor — again within the 1031 deadlines.

The Role of “Parking” Arrangements

A critical rule: you cannot directly take title to the replacement property while improvements are underway.

Instead, the IRS requires a parking arrangement under Revenue Procedure 2000-37. Here’s how it works:

• A third party called an Exchange Accommodation Titleholder (EAT) temporarily holds legal title to the replacement property.

• The EAT typically creates a Special Purpose Entity (SPE) — usually a single-member LLC — solely to hold the property during the exchange.

• This structure ensures legal separation between different clients’ properties and shields investors from potential liens or claims.

Once the exchange period ends and improvements are completed, the EAT transfers the property back to the investor.

Deadlines to Keep in Mind

The same strict timelines apply to Improvement Exchanges as to standard 1031s:

• 45 days – Identify the replacement property and planned improvements.

• 180 days total – Acquire the property and complete all qualifying improvements.

Any improvements not completed within this timeframe will not count toward the exchange value.

Costs and Complexity

Improvement Exchanges are more complicated than standard 1031s because they require:

• Coordinating with a Qualified Intermediary (QI) and an Exchange Accommodation Titleholder (EAT).

• Structuring legal agreements (Qualified Exchange Accommodation Agreement, or QEAA).

• Meeting strict IRS rules on timing and use of funds.

They also come with higher fees than typical exchanges. For that reason, investors should weigh the cost of the transaction versus the amount of taxes deferred to ensure the strategy is worthwhile.

Benefits of Improvement 1031 Exchanges

• Customization – Tailor the replacement property to your investment strategy.

• Maximize Proceeds – Ensure all exchange funds are reinvested, reducing taxable “boot.”

• Value Creation – Improvements can enhance property value and future income.

• Flexibility – Works with both forward and reverse exchange structures.

Risks and Considerations

• Strict Timelines – Improvements must be completed within 180 days. Partial or unfinished work doesn’t qualify.

• Higher Costs – More complex legal, administrative, and intermediary fees.

• Financing Challenges – Lenders may be hesitant while title is “parked” with an EAT.

• Loss of Direct Control – Property is held by a third party during the exchange process.

When Does an Improvement Exchange Make Sense?

An Improvement 1031 Exchange is a powerful tool for investors who want more than a simple “swap” of properties. It allows customization, development, and value-add strategies while still preserving tax deferral.

However, it’s not for everyone. The additional cost, complexity, and rigid timelines mean this strategy makes the most sense for:

• Investors facing large tax liabilities that justify the added expense.

• Developers or value-add investors seeking long-term growth through upgrades.

• Those who already have a trusted team of tax, legal, and exchange professionals.

For the right situation, an Improvement Exchange can turn a tax-driven transaction into a true opportunity to reshape your portfolio.