In a standard 1031 exchange, the replacement property must be of equal or greater value to defer all capital gains taxes. But what happens when an investor wants to acquire a property that costs less than the one they sold? Any unspent proceeds—known as "boot"—become taxable. A construction exchange offers an alternative: directing that excess equity into improvements on the replacement property, preserving the full tax deferral.
The Boot Problem
When an investor sells a relinquished property and acquires a replacement property of lesser value, the difference in price creates "boot." Boot is the portion of exchange proceeds that the investor effectively receives back, and it is taxable as capital gains in the year of the exchange. For many investors, this is an unwelcome outcome that erodes the benefit of the exchange.
Example
An investor sells a property for $1,200,000 and identifies a replacement property valued at $900,000. Under a standard exchange, the $300,000 difference would be taxable boot. In a construction exchange, the investor can direct that $300,000 into qualifying improvements on the replacement property, potentially deferring the entire gain.
What Is a Construction Exchange?
A construction exchange—sometimes called a build-to-suit exchange or improvement exchange—is a variation of the 1031 exchange in which the replacement property undergoes construction, renovation, or improvement using the exchange proceeds. The goal is to increase the value of the replacement property so that it equals or exceeds the value of the relinquished property, thereby eliminating boot and preserving the full tax deferral.
This is accomplished by having the Exchange Accommodation Titleholder (EAT) hold title to the replacement property while improvements are completed. Because the EAT—not the taxpayer—owns the property during the construction period, the improvements add to the overall exchange value.
How It Works
The Process Step-by-Step
- 1 Sell the Relinquished Property:
The investor sells the original property. Proceeds go to the qualified intermediary, as in any 1031 exchange.
- 2 EAT Acquires Replacement Property:
An Exchange Accommodation Titleholder takes title to the replacement property. Exchange funds are used for the purchase.
- 3 Construction or Improvements:
While the EAT holds title, the remaining exchange proceeds fund construction, renovations, or other qualifying improvements on the property.
- 4 Transfer to Taxpayer:
Once improvements are complete—or the 180-day deadline arrives—the EAT transfers the improved property to the investor, completing the exchange.
Critical Rules and Deadlines
A construction exchange is governed by the same fundamental deadlines as any 1031 exchange, but the interplay between construction timelines and exchange deadlines requires careful planning.
45-Day Identification Period
The investor must identify the replacement property and the intended improvements within 45 days of selling the relinquished property. The identification should describe both the property and the planned construction scope.
180-Day Exchange Period
All improvements must be substantially complete, and the property must be transferred to the investor, within 180 days of the sale of the relinquished property. Any exchange proceeds not spent on improvements by this deadline may be treated as boot.
EAT Must Hold Title
The improvements must be made while the EAT holds title to the property. Once the property is transferred to the taxpayer, any subsequent improvements do not count toward the exchange value.
The 180-Day Challenge
The most common difficulty in a construction exchange is completing the improvements within the 180-day window. Permitting delays, supply chain issues, contractor scheduling, and weather can all interfere with the construction timeline. Any funds that remain unspent at the 180-day mark may be treated as taxable boot.
What Qualifies as an Improvement?
The IRS does not specifically define what constitutes a qualifying improvement in the context of a construction exchange. However, improvements generally include:
- New construction on vacant land
- Substantial renovations or remodeling
- Additions to existing structures
- Major infrastructure work (roads, utilities, site preparation)
- Tenant improvements in commercial properties
Personal property items such as furniture or equipment that are not permanently affixed to the real property generally do not qualify under the current rules following the Tax Cuts and Jobs Act of 2017, which limited 1031 exchanges to real property.
Is a Construction Exchange Right for You?
A construction exchange can be a powerful strategy for investors who want to acquire a property that needs work and reinvest their full exchange proceeds. It is particularly well-suited for investors who:
- Have identified a replacement property that is priced below the value of their relinquished property
- Want to add value through construction or renovation
- Have a realistic plan to complete improvements within the 180-day exchange period
- Are comfortable with the added complexity and cost of an EAT structure
Because a construction exchange involves coordinating real estate transactions, construction projects, and strict IRS deadlines simultaneously, working with experienced professionals is not optional—it is essential.
Considering a Construction Exchange?
Fidelis 1031 Exchange has guided investors through construction exchanges nationwide for over 20 years. Contact us to discuss whether a build-to-suit or improvement exchange is the right strategy for your next transaction.
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