Clients often ask whether they can use exchange funds to alter or renovate replacement property. The answer is no! Improvements to real estate are personal property until installed and they become fixtures, so if exchange funds are used for this purpose it will be treated as if the taxpayer had not acquired replacement property with that portion of the exchange funds.

There are two ways this can be done. The first and simplest is to have the seller make the improvements before the property is acquired in the exchange. If the seller is willing to incur the cost, the exchanging taxpayer can simply pay the additional cost at purchase and then make use of exchange funds. If the seller is unwilling to incur the cost, the taxpayer can loan him the funds. When the property is acquired, the seller will repay the loan but the taxpayer will pay a price that includes the cost of the improvements and thereby make use of the exchange funds.

The more complicated method is to use a reverse exchange. An accommodator would acquire the replacement property and make the improvements while it is parked. The taxpayer must loan the funds necessary to acquire the property to the accommodator. This could be done by borrowing against the replacement property or the relinquished property. In a reverse exchange the taxpayer is allowed to lease the property from the accommodator so the lease can be structured to allow the taxpayer to make the improvements to the property. When the replacement property is acquired in the reverse exchange, the loan for acquisition is repaid from the purchase price.

These exchange are “build to suit” and it is possible for a taxpayer to use either of these methods to construct an entire building on vacant land to be acquired as replacement property in an exchange.