In an improvement exchange you complete the sale of the old relinquished property transaction the same as a normal exchange. But when you identify the replacement property you include with the property description a listing of the improvements desired that will use up your exchange credits.  For example, assume that you bought real property years ago for $100,000 and now are able to sell it for a net sales price of $500,000.  Assume that you find a new replacement property currently worth $300,000; normally you would have taxes due on the $200,000 difference in fair market value. However, if the title is (a) held by the qualified intermediary who (b) uses the remaining $200,000 to pay for the improvements and (c) transfers title to you within the 180 day exchange period, it can be fully tax-deferred exchange.

This is covered in Treasury Regulation 1.1031(k)-1(e).  What an improvement exchange essentially does is delay the transfer of title to you (which ends the exchange) until the improvements are done and the new improved value is the equivalent of what you sold. When the Exchanger (you) receives title to the property any remaining work to be completed with funds from the exchange is considered boot and thus taxable. Therefore prepaid labor and building materials left on the site but not installed are not considered real property and cannot be counted as part of the exchange.

Not all accommodators will participate in the improvement exchange because of the extra time and paperwork required and the potential liabilities for accidents or work not completed properly. Normally the exchanger approves all work orders and signs off on all invoices and the qualified intermediary then pays those invoices from the remaining exchange funds. The exchanger, his relatives, or agents may not be paid for completing these improvements. Improvements to real property need not be completed; so long as the value of the new replacement property reaches the value of the old relinquished property the deferral is valid. If the improvement involves personal property, it must be one hundred percent completed.