Can I Use 1031 Funds to Build on Property I Already Own?

A 1031 exchange allows an investor to defer capital gains taxes on the sale of a business or investment property by reinvesting the proceeds into a “like-kind” replacement property. It is possible to use these funds to build on land the investor already owns, but it is a complex process that requires a specific legal structure to comply with Internal Revenue Service (IRS) regulations. A simple, direct use of the funds for construction on your own land is not permitted.

This transaction, known as an improvement or construction exchange, cannot involve the taxpayer directly receiving or controlling the sale proceeds. To navigate this, a specialized arrangement must be established before the original property is sold. The structure ensures the transaction is treated as an exchange of one property for another, rather than a sale followed by a new investment.

The Required Parking Arrangement Structure

To execute an improvement exchange on land you already own, a “parking arrangement” is used where a third party controls the property during construction. The required workaround involves leasing your land to a third party known as an Exchange Accommodation Titleholder (EAT). You must lease your land to the EAT for a term of 30 years or more. The IRS considers a long-term leasehold of this duration to be a “like-kind” real property interest, which validates the transaction.

The EAT holds this leasehold interest, allowing the exchange funds to be used for construction without you having “constructive receipt” of the money. The EAT uses the funds to build the improvements on the land it controls via the lease. At the end of the process, you acquire the leasehold estate back from the EAT, which now includes the value of the newly constructed improvements.

This formal separation is a requirement. The EAT acts as a temporary lessee, receiving funds from the Qualified Intermediary (QI) and disbursing them for labor and materials. This process transforms what would be a non-qualifying construction project into the acquisition of a valid like-kind replacement property, which is the improved leasehold.

Information and Decisions Before Starting

Preparation must begin before the relinquished property is listed for sale. You must have detailed construction plans and specifications ready, as they must be comprehensive enough to form the basis of contracts and be identified as part of the exchange.

A 45-day identification period begins the day you sell your original property. Within this window, you must provide a written identification of the replacement property to your Qualified Intermediary (QI). For an improvement exchange, this means identifying the leasehold interest and a detailed description of the improvements. An identification might read: “A leasehold interest in the real property located at [address], together with the construction of a 10,000-square-foot warehouse as detailed in the architectural plans prepared by [Architect’s Firm], dated [Date].”

The second deadline is the 180-day exchange period. All construction counted toward the replacement property’s value must be completed, and the title transferred from the EAT back to you, within 180 days of the original sale. Delays can jeopardize the exchange, as only the value of completed improvements is counted.

Finally, you must engage a QI with experience in improvement exchanges, as the QI will establish the EAT entity. You should vet potential QIs on their expertise, fee schedules, and their process for handling construction draws and disbursements.

The Improvement Exchange Process

With the legal structure in place, you sell your relinquished property. The sale proceeds are wired directly to the Qualified Intermediary (QI), not to you. Immediately following the sale, you enter into a long-term ground lease with the Exchange Accommodation Titleholder (EAT), giving it control over the land where construction will commence.

As construction progresses, the QI disburses the exchange funds to the EAT according to a pre-arranged draw schedule. The EAT then pays contractors and suppliers for materials and labor. This process ensures that the 1031 funds are used exclusively for the intended improvements.

The final step must occur before the 180-day deadline expires. Once construction is finished, or as much of it as can be completed within the timeframe, the EAT transfers the leasehold interest, along with the newly built improvements, back to you to complete the exchange.

Calculating Value for the Exchange

To achieve full tax deferral, the value of the replacement property you acquire must be equal to or greater than the value of the relinquished property you sold. In an improvement exchange, the value of the replacement property is the cost of the new construction paid for with the 1031 exchange funds. This includes all costs for labor and materials permanently incorporated into the real estate within the 180-day exchange period.

Because you retain ownership of the land, its value does not count toward the replacement property value. You are only acquiring the improvements constructed on your land via the leasehold transfer, so the entire value of your sold property must be reinvested into the new construction.

For example, assume you sell a property for $1 million. To fully defer taxes, you must use the full $1 million of exchange proceeds to construct improvements on your land. The value of the land itself is not part of this calculation. The replacement property you acquire from the EAT must have a value of at least $1 million, based solely on the new construction.