1031 Exchanges have been in the tax code since 1921 allowing property owners the ability to defer tax on qualifying real estate transactions by reinvesting the funds from the sale of their initial property into new qualifying real estate. Since its introduction in the tax code over 100 years ago, 1031 Exchanges have taken different forms; in 2000 safe harbors were introduced specific to “parking exchanges,” including Improvement Exchanges, which allow for the use of exchange funds toward property improvements and new construction on the property being acquired as part of a 1031 Exchange.
In addition to 1031 Exchanges, additional legislative measures have been introduced over time to reduce tax liabilities to stimulate capital investments and economic activity. This includes the recent H.R.1, also known as The One Big Beautiful Bill Act (OBBBA), which enhanced and extended many specific initiatives within the Tax Cuts and Job Acts (TCJA), including Section 179 expensing and 100% Bonus Depreciation. Both incentives allow businesses to immediately deduct the full purchase price or full expense of qualifying improvements in the year it occurred as opposed to having to deduct it over several years.
The article will explore how Improvement Exchanges can be used in combination with Section 179 expensing and 100% Bonus Depreciation on qualified improvements to offset taxable income or negate a taxable event by offsetting “boot” through improvements on Replacement Property.
Overview of 1031 Improvement Exchanges
Improvement Exchanges, also known as Build-to-Suit or Property Improvement Exchanges, allow an Exchanger to use a portion of their exchange funds to complete improvements and/or build new construction on the property being purchased as part of the exchange, the Replacement Property.
Improvements can vary from cosmetic to extensive structural improvements that require building from the ground-up. They can also be structured as a Forward or Reverse Exchange. A Forward Improvement Exchange takes place on the Replacement Property after the Relinquished Property is sold. The Relinquished Property sale proceeds can fund the improvements. A Reverse Improvement Exchange is begun on the Replacement Property prior to the sale of the Relinquished Property, and the improvements are initiated, and sometimes completed, in advance of its sale. Funds used to cover the acquisition and/or improvements can later be paid back once the Relinquished Property sale proceeds are available.
The process of an Improvement Exchanges is key to its success and includes the following:
- Prior to close of the Relinquished Property: The Exchange Agreement is executed to initiate a 1031 Exchange.
- Day 0: Relinquished Property is sold, exchange funds are transferred to the Qualified Intermediary
- On or Before Day 45: Replacement Property Identification
- Identification of potential Replacement Property(ies) are identified following standard ID Rules and Regulations, including a detailed listing of the improvements planned on the property(ies).
- Qualified Exchange Accommodation Agreement (QEAA) is executed allowing for title to the Replacement Property to be “parked” with the Exchange Accommodation Titleholder (EAT) while the improvements are conducted.
- EAT acquires the Replacement Property and the planned improvements are made
- On or Before Day 180: The Replacement Property with wholly or partially completed improvements is transferred from the EAT to the Exchanger and the 1031 Exchange is completed.
- Any exchange funds left over in the exchange account will be returned to the Exchanger as “boot” and create a taxable event.
Below is an example of a basic, forward Improvement Exchange.
An Exchanger sells a warehouse for $5 million with a $2 million basis, resulting in $3 million gain. The Exchanger decides to purchase a dated retail center for $4.5 million and use the remaining $500,000 to pay for improvements on the retail center through an Improvement Exchange. On or before day 45 the Replacement Property must be identified in writing along with the list of improvements planned on the property. Those specific improvements must be completed within the 180-day exchange period for a fully tax deferred transaction.
If an Exchanger is unable to use all exchange funds between the acquisition of the property and the improvements, the transaction is still valid, but they will receive any remaining funds back as “boot” and they will be subject to capital gains, depreciation recapture, state and net investment income taxes.
Bonus Depreciation and Immediate Expensing (Section 179) within H.R.1
When thinking about Bonus Depreciation and immediate expensing for real property, it helps to revisit how we first outlined it in our earlier blog highlighting the sections of The One Big Beautiful Bill Act (OBBBA), or H.R.1, most specific to real estate and real estate investors.
H.R.1 increased the immediate expensing limit from $1.25 million to $2.5 million and increased the phase-out threshold up to $4 million with the full phase-out occurring at $6.5 million. Section 179 expensing applies to items including HVAC systems, roofs, furniture, fixtures, and equipment, fire, alarm and security systems; these items do not qualify for Bonus Depreciation.
H.R.1. permanently reinstated 100% Bonus Depreciation, allowing businesses to immediately deduct 100% of certain qualified expenses within the year they occurred, rather than spreading deductions over decades. For real estate, this doesn’t apply to land, but it does apply to Qualified Improvement Property (QIP) such as drywall, flooring, lighting, electrical, or plumbing upgrades inside a building, as well as Qualified Production Properties (QPP), nonresidential real property integral to manufacturing, refining, agriculture, or similar production activities. Cost segregation studies are often utilized for large-scale projects to determine what qualifies as QIP for Bonus Depreciation and what does not meet the criteria. Investors are able to stack Section 179 expensing and Bonus Deprecation with Immediate expensing being taken first up to annual cap and then Bonus Deprecation being applied to the remainder of the qualifying improvements.
The changes to Section 179 expensing and permanency of Bonus Depreciation enacted in H.R.1. provides more long-term certainty for property owners and investors allowing for more aggressive tax planning specific to Improvement Exchanges. Additionally, they further incentivize capital investment in real estate, specifically property improvements to existing properties.
Combining Strategies: Improvement Exchange, Bonus Depreciation and Immediate Expensing
Property owners are able to combine the tax deferral power of an Improvement Exchange along with the accelerating deductions via Bonus Depreciation and Immediate Expensing to offset taxable income or “boot”. When combined, these strategies allow investors to keep more capital in their hands by reducing immediate tax liability which they can then reinvest.
Using the example above, below is a basic illustration of how a property owner could leverage these tax incentives with an Improvement Exchange.
The Exchanger sells a warehouse for $5 million with a $2 million basis, resulting in $3 million gain. The Exchanger decides to purchase a dated retail center for $4.5 million and use the remaining $500,000 to pay for improvements on the retail center through an Improvement Exchange. Of the $500,000 in improvements, $300,000 of them qualify as QIP as are eligible for 100% Bonus Depreciation. The property owner can take the $300,000 to offset income elsewhere, such as rental income in year one.
A variation from the example above, could be that the Exchanger only pays $250,000 for improvements, all $250,000 qualify as QIP, and that $250,000 can offset the remaining $250,000 in exchange funds that would otherwise be treated as “boot” and subject to all associated taxes.
Some considerations for combining these strategies include:
- Exchange timing: Improvements must be completed by day 180 the end of the exchange period.
- Bonus Depreciation Placed-in-Service: Bonus depreciation can only be applied once the improvements are in place.
- Depreciation Recapture: Depreciation will be subject to Depreciation Recapture when the property is sold, unless it is part of another 1031 exchange.
An Improvement Exchange used in conjunction with Bonus Depreciation creates by tax deferral and deduction acceleration, boosting cash flow and tax efficiency.
Strategic Planning for Optimal Tax Advantages
Improvement Exchanges, Bonus Depreciation, and Immediate Expensing require advanced planning with the help of experts including an experienced Qualified Intermediary and EAT, as well as a seasoned tax advisor.
The Qualified Intermediary and EAT, like Accruit, will provide necessary paperwork to enable the Improvement Exchange to comply per IRC §1031and the Property Improvement from Rev. Proc. 2000-37 rules from the onset. While the tax adviser will work with the Exchanger to determine what qualifies for Bonus Depreciation and Immediate Expensing. It is critical for both parties to work together to ensure optimum tax advantages for the Exchanger.
Accruit has experience facilitating Improvement Exchanges, both simple exchanges like the examples above, as well as very complex transactions that span outside the 180-day exchange period, known as Specialty “Non-Safe Harbor” transactions. Accruit works seamlessly with an Exchanger’s team of advisors, including their tax, legal, and financial advisors, to ensure all parties are comfortable with the strategy and all parties have open lines of communication.
As tax incentives continue to evolve, the combination of 1031 Improvement Exchanges and the permanent reinstatement of 100% Bonus Depreciation under H.R.1 represents one of the most powerful opportunities available to real estate investors today. By thoughtfully integrating these strategies, property owners can not only defer capital gains but also unlock immediate deductions that enhance cash flow and fuel reinvestment. However, these benefits are only realized through careful planning, precise execution, and coordination between a Qualified Intermediary, EAT and trusted tax advisors. With the right team in place, investors can strategically leverage these tools to maximize savings, minimize tax exposure, and position their portfolios for long-term growth.