There is a quiet conflict built into every exchange, and almost nobody names it until the invoice arrives.
The tax rule says reinvest everything. Hold back cash and that cash is boot, taxable to the extent of your gain. So a well-executed exchange closes with the account at zero, every dollar deployed, nothing recognized.
The building says something else. It says the roof is twenty-two years old, two rooftop units are at end of life, and the parking lot needed sealing three summers ago.
The tax rule and the building are both right, and the exchanger sits between them holding no cash.
The arithmetic of holding money back
Say you have $1,400,000 of proceeds and a roof that needs $80,000 within two years.
Keep the $80,000 out of the exchange and it is cash boot. At 20% federal capital gains plus the 3.8% net investment income tax, that is roughly $19,040 in tax, before any state. You paid about nineteen thousand dollars for the privilege of having your own money available for your own roof.
Reinvest it instead and you defer that tax completely. You also own a building with a failing roof and no reserve.
That is the trade, and it is genuinely a trade rather than an obvious answer.
Four ways through it
Bring outside cash. The cleanest option by a distance. Money you add to the replacement side is not boot, it increases your basis, and it funds the work. If you have liquidity outside the exchange, this is almost always the right answer and it is the one we push hardest.
Accept the boot deliberately. Sometimes the honest answer. If the alternative is expensive borrowing or deferring critical work, paying roughly 23.8% on a modest holdback to stay liquid can beat the alternatives. The important word is deliberately: boot you chose is a decision, boot you discovered in April is a mistake.
Build it into the financing. A lender escrow or capital reserve funded at closing forms part of the acquisition rather than cash returning to you. Many lenders require reserves on older assets anyway. This is frequently the most efficient route and it needs arranging before closing, not after.
Negotiate a seller credit. Attractive on its face and genuinely fiddly in practice, because a credit can be treated as a reduction in purchase price, which affects the value you are replacing and can itself create exposure. Your CPA needs to see the settlement statement before you agree the structure, not after.
| Hold back cash | Bring outside cash | Lender reserve at closing | |
|---|---|---|---|
| Creates boot | Yes | No | Generally no |
| Tax on $80,000 | About $19,040 | $0 | $0 |
| Effect on basis | Reduces reinvestment | Increases basis | Part of acquisition |
| Needs arranging in advance | No | No | Yes |
| Requires outside liquidity | No | Yes | No |
The option most people skip
Buy something that does not need the work.
It sounds facile and it is the most underused answer on the list. Inside a 45-day window, buyers gravitate to whatever is available rather than whatever is appropriate, and a tired asset at an attractive yield is exactly what tends to be available. A property with a three-year-old roof and recent mechanical replacement can be worth materially more to an exchanger than the yield spread suggests, precisely because the exchanger has no capital left for surprises.
That is why the condition work has to happen before you identify, not after:
- Commission a property condition assessment, and read the immediate-repair table rather than the summary.
- Get real contractor bids on anything large. Assessment estimates are planning numbers and they run low.
- Build the twelve-year replacement schedule for roof, mechanical, paving, and envelope, and check it against your actual cash flow rather than the broker's.
- Confirm what the tenants owe. In a net lease, some of this may be recoverable, and an estoppel tells you what tenants believe rather than what the seller says.
The passive version of the same problem
Worth noting that reserves are one of the genuine arguments for a DST: capital planning becomes the sponsor's job rather than yours, and there is no 3am call about a roof.
That only helps if the reserves are actually adequate, which is a diligence question rather than an assumption, and it connects directly to how distributions are funded. A sponsor running thin reserves while paying an attractive distribution has made a choice you will eventually pay for, which we covered in what a distribution rate does not tell you. DSTs are offered to accredited investors through private placement and carry real risks including illiquidity, fees, and loss of principal.
Whichever route you take, decide it before closing while all four options are still open. Your CPA determines the boot consequences for your specific numbers, and sequencing that conversation early is what our exchange process is built to do.
Common questions about capital reserves and exchanges
Can I keep some exchange proceeds back for repairs?
You can, but withheld cash is boot and taxable to the extent of your gain. On $80,000 that is roughly $19,040 federally before state tax.
What is the cheapest way to fund capital work after an exchange?
Usually bringing cash from outside the exchange, which is not boot and increases your basis. A lender reserve funded at closing is often the next best.
Does a seller credit for repairs create a problem?
It can. A credit may be treated as a reduction in purchase price, which affects the value you are replacing. Have your CPA review the settlement statement before you agree it.
Should I ever accept boot on purpose?
Sometimes. If the alternative is expensive debt or deferring critical work, paying tax on a modest holdback can be the better outcome. Decide it deliberately rather than by accident.
How do I avoid the problem entirely?
Underwrite condition before you identify, and give real weight to properties that do not need immediate capital. An exchanger closes with no cash, which makes recent capital work worth more than it looks.
Disclosure: Numerical example is for illustration purposes only; individual circumstances will vary.