Can I use exchange funds for repairs after closing on the replacement property?

The exchange ends at the deed, and the regulation says so in one line

Reg. §1.1031(k)-1(e)(4) opens by saying a transfer of relinquished property is outside §1031(a) if it is made in exchange for services, including production services, and then draws the conclusion: production after you receive the property is not the receipt of like-kind property.

Paragraph (e)(3)(iii) sets the matching test for an unfinished building. Real property still under construction counts as substantially the same property as identified only to the extent what you receive “constitutes real property under local law” — in other words, only the part that is physically there on the day of transfer.

The practical consequence is that a build-to-suit has to be built before you own it, not after. A half-finished shell transferred on day 180 counts for the value of the shell, and the concrete poured in month seven counts for nothing.

So a $40,000 rooftop solar array installed in month two is two separate events: a $40,000 cash-boot event on the exchange, and a new depreciable asset on your schedule. It does not reduce the boot by a dollar.

What the intermediary's cheque actually costs, in round numbers

Take a hypothetical. Your rental sells for $980,000 against an adjusted basis of $340,000, the replacement costs $925,000, and you ask the intermediary to hold back $55,000 for a new roof and a solar install once the deed is yours.

On Form 8824 that $55,000 goes on line 15 as cash received, and line 20 makes all of it recognised gain because the realised gain is far larger. The roof and the panels then start their own depreciation lives, but the tax on the $55,000 falls in the year you take it.

Where that gain lands on the return is set out in boot and recapture on Form 4797 and Schedule D, and what boot is in the first place is covered in what is boot in a 1031 exchange.

The improvement exchange: someone else owns the dirt while the work happens

Rev. Proc. 2000-37 created the safe harbour. An exchange accommodation titleholder — a party that is neither you nor a disqualified person, and that is subject to federal income tax — takes qualified indicia of ownership of the replacement property and holds them throughout.

Within five business days you and the titleholder sign a qualified exchange accommodation agreement stating that it holds the property for your benefit to facilitate a §1031 exchange and that both of you will report it as the beneficial owner. Within 45 days of it taking title you identify the relinquished property, and within 180 days the property must be transferred to you as replacement property.

Section 4.02(6) is the hard stop: the combined time the relinquished property and the replacement property are held in the arrangement cannot exceed 180 days. That, not the construction schedule, is what sizes the project.

• What the titleholder must have at all times: legal title, another indicium of beneficial ownership under commercial law such as a contract for deed, or the interests in a disregarded single-member LLC that holds title.
• What it must not be: you, or a disqualified person under Reg. §1.1031(k)-1(k), which rules out your own attorney, accountant or agent of the last two years.
• What happens if a requirement is missed — for example the transfer does not occur inside 180 days: §3.04 says the revenue procedure simply does not apply, and ownership is then decided on ordinary benefits-and-burdens principles.
• What the arrangement does not do: it does not extend your 45-day or 180-day deadlines, which run as usual — see can I get an extension on my deadlines.

You are allowed to pay for the work, supervise it and guarantee the debt

The safe harbour anticipates that the titleholder has no money of its own. Section 4.03 lists arrangements that will not spoil the structure even on terms that would not arise between unrelated parties.

Those permissions are why an improvement exchange is workable for an ordinary owner rather than only for institutions.

• §4.03(2): you may guarantee the titleholder's obligations, including secured or unsecured debt incurred to acquire the property, and indemnify it against costs.
• §4.03(3): you may lend or advance funds to the titleholder, or guarantee a loan to it — this is how exchange equity and new financing reach the construction budget.
• §4.03(4) and (5): the property may be leased back to you, and you may manage it, supervise the improvement work or act as the contractor.
• §4.03(1): a party that meets the qualified intermediary safe harbour may serve as both the intermediary and the titleholder.

Why the intermediary cannot simply pay your contractor

There is a second obstacle, independent of the production rule. Reg. §1.1031(k)-1(g)(6) requires the agreement to provide that you have no rights to receive, pledge, borrow or otherwise obtain the benefits of the money before the end of the exchange period, subject only to the narrow exceptions where no property was identified, where you have received everything you are entitled to, or where a material and substantial contingency beyond your control occurs.

Directing that money to a contractor working on a building you already own is obtaining the benefit of it. The limits on touching exchange funds mid-stream are set out in can I touch, borrow against or pledge my exchange funds.

Costs paid at the closing itself are a different question with its own answer — see which closing costs can be paid from exchange funds.

Three honest options for the money you were going to spend on the building

The first is to buy more replacement value instead: a second property, or a Delaware Statutory Trust interest sized to the exact remainder, which is often the only thing that can close inside the time left. Sizing is covered in DST minimum investment sizes and splitting an exchange between a DST and a direct purchase.

The second is to accept the boot, pay the tax on it, and fund the work with a refinance or cash — often the right answer when the amount is small relative to the deal. The third is to plan an improvement exchange before the relinquished property closes, which is the only route that gets construction dollars inside the exchange at all; the structure is laid out in improvement and build-to-suit exchanges.

Have a CPA or attorney price the boot against the construction budget before you sign a qualified exchange accommodation agreement, because the extra closings and titleholder fees are real. As a broker placing exchange equity with vetted national Delaware Statutory Trust sponsors, a remainder-sized interest is the single thing we are asked for most often in this situation.