Understanding Leasehold Improvement Exchanges in 1031 Transactions
In a traditional 1031 Exchange, investors sell one investment property and reinvest the proceeds into another like-kind property to defer capital gains taxes. But what happens when the ideal replacement property requires improvements—or when the land itself is owned by a related party?
That’s where a Leasehold Improvement Exchange comes in. Under certain conditions, the IRS allows taxpayers to complete improvements or even build new construction on leased land—provided the exchange is structured correctly and follows strict timing and ownership rules.
This guide explains how Leasehold Improvement Exchanges work, when they’re allowed, and what investors should know about using them within the 1031 framework.
What Is a Leasehold Improvement Exchange?
A Leasehold Improvement Exchange (sometimes called an “improvement exchange” or “build-to-suit exchange”) allows an exchanger to use 1031 funds to make improvements on a replacement property before taking ownership.
In this setup, the exchanger typically acquires a long-term leasehold interest—often 30 years or longer—in the land or property. The improvements built on that leased land become part of the replacement property for exchange purposes.
This strategy can also be used when the land is owned by a related party, as long as specific IRS requirements are met.
How It Works
Here’s how a Leasehold Improvement Exchange typically unfolds:
Establish a Long-Term Lease:
The exchanger (or an exchange accommodation titleholder, known as an EAT) enters into a long-term ground lease on the land—often for 30 years or more.
Construct or Improve the Property:
Using exchange proceeds, improvements such as buildings, renovations, or infrastructure are made on the leased land during the 180-day exchange period.
Transfer of the Improved Property:
Once improvements are completed (or substantially completed) within the exchange window, the exchanger receives the leasehold interest along with the improvements as the replacement property.
To qualify under IRS rules, the improvements must exist before the exchanger takes title. Funds cannot be used after the exchange closes to continue construction.
Related Party Considerations
A Leasehold Improvement Exchange often involves land owned by a related party—such as a family member or an entity under common ownership. Normally, direct exchanges between related parties are highly restricted under IRS Section 1031(f), particularly if one party cashes out within two years.
However, the use of a leasehold structure can allow the transaction to qualify, provided that:
The lease is bona fide and long-term (30 years or more).
The related party retains ownership of the underlying land.
The exchanger’s interest is limited to the leasehold and improvements.
The arrangement does not function as a disguised sale or tax avoidance mechanism.
Proper documentation and third-party administration are essential to establish that the exchange meets IRS requirements.
Timing Rules
Just like any other 1031 Exchange, timing is critical:
45 days to identify the leasehold or property being improved.
180 days to complete the exchange, including construction or improvements.
All work must be finished, and the improved property must be received by the exchanger within that 180-day period to qualify for full tax deferral.
When a Leasehold Improvement Exchange May Be Advantageous
This structure can be particularly useful when:
The ideal replacement property isn’t yet built or requires major renovations.
The exchanger wants to improve the property before taking ownership.
The land is owned by a related entity but can be leased under fair market terms.
It provides flexibility while maintaining compliance with 1031 Exchange rules—when carefully planned and executed.
Making the Structure Work
A Leasehold Improvement Exchange allows investors to complete new construction or improvements on leased land—including land owned by a related party—within the 1031 framework. To qualify, the lease must be long-term, the improvements must be completed before title transfer, and the structure must follow IRS timing and ownership rules.
Because of the complexity involved, it’s essential to work with a Qualified Intermediary, tax advisor, and legal counsel experienced in build-to-suit and related-party exchanges.
Disclaimer
This article is for informational purposes only and does not constitute legal or tax advice. Investors should consult a Qualified Intermediary, CPA, or tax attorney before pursuing a Leasehold Improvement Exchange to ensure compliance with IRS Section 1031 regulations.
