Repair costs in a 1031 exchange cannot be paid from the funds your Qualified Intermediary is holding. Only capital improvements qualify, and even those require a specific structure — an improvement exchange run through an Exchange Accommodation Titleholder — so that you never touch the money directly. Routine maintenance funded from exchange proceeds is treated as taxable cash received, which is exactly the outcome the exchange was designed to avoid.
Why Paying for Repairs Creates Boot
The 1031 framework depends on the taxpayer never having actual or constructive receipt of the exchange proceeds. The Treasury regulations require that your exchange agreement expressly deny you the right to receive, pledge, borrow, or otherwise benefit from the funds during the exchange period.1eCFR. 26 CFR 1.1031(k)-1 – Treatment of Deferred Exchanges
Having the QI cut a check for repairs on your behalf does not solve the problem. Even though the money never lands in your personal account, the QI is acting on your direction to spend exchange funds on a non-qualifying expense. The IRS treats that the same as if you had withdrawn the cash yourself. The funds left the exchange for a purpose that isn’t acquiring like-kind property and isn’t a qualifying transaction cost, and that ends the analysis.
There is a second, structural reason repairs cause damage. To defer 100 percent of the gain, the net value of your replacement property must equal or exceed the net value of what you sold. Any shortfall is boot, and boot is immediately taxable. Money spent on a deductible repair is money that didn’t get reinvested into the replacement property’s value, so it counts against you on the reinvestment ledger. A repair paid from exchange funds is boot twice over: once because the disbursement itself violates the safe harbor, and once because the dollars never made it into the acquired property.
What Counts as a Repair Versus a Capital Improvement
The line between the two determines whether exchange funds can ever cover the work. The IRS tangible property regulations apply three tests. An expenditure must be capitalized as an improvement if it meets any one of them.2Internal Revenue Service. Tangible Property Final Regulations
- Betterment: the work fixes a pre-existing defect, adds material square footage or a new component, or materially increases productivity, efficiency, or output.
- Restoration: the work replaces a major component or substantial structural part, or returns a property that has deteriorated beyond functional use back to working condition.
- Adaptation: the work converts the property to a new or different use inconsistent with its original purpose, such as turning a warehouse into retail.
A repair, by contrast, keeps the property running in its ordinary condition. Patching drywall, repainting, replacing a broken window, or fixing a leaky faucet are repairs. They are deductible as current operating expenses and cannot be funded with exchange proceeds.2Internal Revenue Service. Tangible Property Final Regulations
The gray area is where investors get burned. Replacing a few shingles after a storm is a repair. Replacing the entire roof system is a restoration of a major structural component, which makes it a capital improvement. Installing a new HVAC system is a betterment. Servicing the existing one is a repair. When the answer isn’t obvious, the IRS looks at whether the work was done to a “unit of property” — the building structure, a building system like plumbing or electrical, or a major component — and whether it crosses one of the three thresholds above.
The De Minimis Safe Harbor Cuts the Other Way
For smaller expenditures, the IRS offers a de minimis safe harbor letting you deduct amounts up to $2,500 per item or invoice ($5,000 with audited financial statements) without analyzing whether they’re improvements or repairs. This election is convenient in ordinary property management, but it works against you in an improvement exchange. An item expensed under the safe harbor is, by definition, not a capital improvement, so exchange funds cannot pay for it.
How to Fund Capital Improvements With Exchange Money
If you want exchange proceeds to pay for qualifying improvements on the replacement property, you need an improvement exchange (sometimes called a construction exchange or build-to-suit exchange). The core rule is that you can never take direct possession of the funds, even temporarily. Money moves from the QI to the contractors without passing through your hands or your bank account.1eCFR. 26 CFR 1.1031(k)-1 – Treatment of Deferred Exchanges
The mechanism is the Exchange Accommodation Titleholder. The QI sets up a single-purpose LLC, and this entity takes title to the replacement property on your behalf. While the EAT holds title, the QI disburses exchange funds directly to contractors for capital improvement work. The IRS safe harbor for this arrangement comes from Revenue Procedure 2000-37, which provides that the IRS will not challenge the EAT’s ownership or the exchange’s qualification, provided the arrangement meets the specified requirements and the property doesn’t sit with the EAT for more than 180 days.3Internal Revenue Service. Revenue Procedure 2000-37
The 180-Day Constraint on Construction
Every improvement must be completed and the property conveyed back to you within the same 180-day exchange window that governs any deferred exchange. Within the first 45 days you must identify both the replacement property and the specific improvements you plan to make, described in detail on your identification notice to the QI. The rest of the time is for purchasing, building, and closing the transfer back to you.
If construction isn’t finished by day 180, only the value of completed work counts toward the equal-or-greater-value requirement. Anything planned but not built becomes taxable boot. An investor who budgeted $200,000 in improvements but only completed $140,000 worth of work has $60,000 in potential boot. Realistic scoping matters. Overambitious renovation plans are one of the fastest ways to trigger an unintended tax bill.
What the EAT Can Actually Pay For
The EAT can disburse exchange funds only for costs that become part of the real property. Labor and materials for structural work, new building systems, and permanent fixtures qualify. Payments cannot go toward personal property that’s merely placed on the premises without being incorporated into the real estate. Furniture, free-standing appliances, and equipment that can be removed without damaging the structure do not count. The QI should keep detailed records showing every disbursement, the contractor who received it, and the specific improvement it funded.
Closing Costs the QI Can Pay Without Creating Boot
Separate from improvements, certain closing costs can be paid directly from the exchange account. These are expenses necessary to complete the exchange transaction itself:
- QI facilitation fees
- Title insurance premiums
- Escrow and recording fees
- Real estate broker commissions
- Attorney fees for drafting closing documents
- Transfer taxes and appraisal fees
Paying these from exchange funds is actually helpful. It reduces the cash you would otherwise receive and keeps more money inside the exchange, which minimizes boot. Itemize them clearly on the closing statement so the QI can account for each one.
What the QI cannot pay from exchange funds: loan origination fees and points on the replacement property mortgage, property insurance premiums, prepaid rent credits, tenant security deposits transferred at closing, and any ongoing operating expenses. These are financing or income items, not exchange expenses. Using exchange funds for any of them creates taxable boot in the same way repairs do.
What Boot Actually Costs at Tax Time
Boot is taxed as capital gain in the year you receive it, up to the total realized gain on the relinquished property. For 2026, federal long-term capital gains rates are 0, 15, or 20 percent depending on your taxable income. Single filers reach the 20-percent bracket above $545,500 in taxable income; joint filers above $613,700.
Real estate carries an extra layer. Any depreciation you previously claimed on the relinquished property is subject to unrecaptured Section 1250 gain, taxed at a maximum federal rate of 25 percent when the gain is recognized. This regularly surprises investors who assumed everything would be taxed at 15 percent.4Internal Revenue Service. Topic No. 409, Capital Gains and Losses
Higher-income investors may also owe the 3.8 percent Net Investment Income Tax on top of the capital gains rate. It applies to the lesser of net investment income or the amount by which modified adjusted gross income exceeds $200,000 (single) or $250,000 (married filing jointly). Those thresholds are not inflation-adjusted, so more taxpayers cross them each year. Stack all three layers together and boot on a depreciated property can be taxed at federal rates approaching 30 percent before any state tax applies. A few thousand dollars in “small” repairs paid from the exchange account can trigger a five-figure tax hit.
If your goal is to freshen up the property for tenants, pay for repairs with your own funds outside the exchange. If the work is substantial enough to qualify as a capital improvement, set up an improvement exchange before closing on the relinquished property — trying to bolt one on afterward doesn’t work, because the EAT has to be in place to take title.