When you sell an investment property for a profit, you usually owe capital gains tax and depreciation recapture. For long-time investors, that tax bill can be large enough to limit how much they can reinvest. A 1031 exchange, named for Section 1031 of the Internal Revenue Code, lets you defer those taxes by reinvesting the proceeds in another qualifying property. It is one of the most widely used tax strategies in real estate, but it comes with strict rules and deadlines. This guide explains how a 1031 exchange works, which properties qualify, the timelines, and common mistakes. Because the rules are technical, work with a qualified intermediary, a tax professional, and a real estate attorney.
What a 1031 exchange is
A 1031 exchange, also called a like-kind exchange, allows you to sell real property held for investment or business use and buy other like-kind real property without recognizing the gain at the time of the sale. The tax is deferred, not eliminated. Your basis in the old property generally carries over to the new property, so the deferred gain may be taxed when you eventually sell without another exchange.
Since the Tax Cuts and Jobs Act took effect in 2018, Section 1031 applies only to real property. Exchanges of equipment, vehicles, artwork, and other personal property no longer qualify.
Which properties qualify
Both the relinquished property (the one you sell) and the replacement property (the one you buy) must be held for productive use in a trade or business or for investment. “Like-kind” is interpreted broadly for real estate. Examples of qualifying exchanges include:
- A rental house for an apartment building
- Raw land for a commercial building
- An office building for a retail center
- A duplex for several single-family rentals
Properties that generally do not qualify include:
- Your primary residence
- Property held primarily for sale, such as fix-and-flip homes or a developer’s inventory
- Property outside the United States exchanged for property inside the U.S., or vice versa
- Stocks, bonds, partnership interests, and other securities
Vacation homes may qualify only in limited circumstances, such as when they meet IRS safe harbor rules for rental and limited personal use.
The key deadlines
Strict timing rules apply, and the IRS generally does not grant extensions except in declared disasters.
The 45-day identification period
Within 45 days of closing on the sale of the relinquished property, you must identify potential replacement properties in writing, signed and delivered to the qualified intermediary or another permitted party. Common identification rules include:
- Three-property rule. Identify up to three properties of any value.
- 200% rule. Identify any number of properties, as long as their total value does not exceed 200% of the relinquished property’s value.
- 95% rule. Identify more, but you must acquire at least 95% of the total value identified.
The 180-day exchange period
You must close on the replacement property within 180 days of the sale or by the due date of your tax return, including extensions, for the year of the sale, whichever comes first. The 45-day period runs concurrently, not in addition. If your sale closes late in the year, you may need to file an extension to get the full 180 days.
The role of a qualified intermediary
In a typical delayed exchange, you cannot receive or control the sale proceeds. A qualified intermediary (QI), sometimes called an exchange accommodator, holds the funds and transfers them to buy the replacement property. If you take possession of the money, even briefly, the exchange can fail and the gain becomes taxable.
Your QI cannot be your agent, such as your attorney, accountant, or real estate agent who has worked for you in the past two years, or a related party. Choose an experienced, reputable QI with strong safeguards for client funds, since the industry is not heavily regulated in every state.
Boot and partial taxation
To defer all of the gain, you generally must:
- Buy replacement property of equal or greater value than what you sold
- Reinvest all of the net proceeds
- Replace any mortgage debt paid off with new debt or additional cash
Anything you receive that is not like-kind property, such as cash or a reduction in debt, is called boot and is generally taxable up to the amount of your gain. For example, if you sell for $800,000 and buy for $700,000, the $100,000 difference may be taxable.
Depreciation recapture
Investment real estate is depreciated over time, which reduces your basis. When you sell without an exchange, part of the gain attributable to depreciation is generally taxed at a maximum 25% rate for real property. A 1031 exchange defers both capital gains and depreciation recapture. The replacement property’s basis reflects the carried-over basis, so future depreciation deductions may be smaller.
Types of 1031 exchanges
- Delayed exchange. The most common type. You sell first, then buy within the deadlines.
- Reverse exchange. You buy the replacement property before selling the old one. An exchange accommodation titleholder holds one property temporarily. These are more complex and costly.
- Improvement or build-to-suit exchange. Exchange funds are used to make improvements on the replacement property before you take title, within the 180-day period.
- Simultaneous exchange. Both closings occur on the same day.
Related party rules
Exchanges between related parties, such as family members or entities you control, are allowed but subject to special rules. Generally, both parties must hold the exchanged properties for at least two years, or the deferred gain may become taxable.
Reporting the exchange
You report a 1031 exchange on IRS Form 8824, Like-Kind Exchanges, with your tax return for the year you sold the relinquished property. The form records the properties, dates, values, and any gain recognized. Keep documentation of the exchange, including the QI agreement, identification notice, and closing statements.
An example
Daniel bought a rental house years ago for $300,000 and has taken $80,000 in depreciation, so his adjusted basis is $220,000. He sells it for $600,000, a gain of $380,000. Instead of paying tax on that gain, he uses a QI and, within 45 days, identifies three small apartment buildings. He closes on a $650,000 building within 180 days, reinvesting all proceeds and taking on a larger mortgage. Because he received no boot, the entire gain is deferred. His basis in the new property is roughly his old adjusted basis plus the additional money he invested.
The estate planning angle
Some investors use a series of 1031 exchanges over a lifetime. Under current law, heirs who inherit property generally receive a basis stepped up to fair market value at the owner’s death, which can eliminate the deferred gain for income tax purposes. This “swap till you drop” strategy is common, but tax laws can change, so consult an estate planner.
Common mistakes
- Touching the money. Receiving proceeds directly can disqualify the exchange.
- Missing deadlines. The 45-day and 180-day periods are strict.
- Exchanging property not held for investment, such as a flip or a primary home.
- Unexpected boot, from cash left over or paying off debt without replacing it.
- Choosing a weak QI, which can put your funds at risk.
- Ignoring state taxes. Some states have their own rules, including tracking gains on property exchanged out of state.
Related reading: Earned Income Tax Credit: Who Qualifies, How It Is Figured, and How to Claim It Correctly and Home Office Deduction: Who Qualifies and How to Calculate It.
Frequently Asked Questions
What is a 1031 exchange?
It is a tax strategy that lets investors defer capital gains and depreciation recapture by reinvesting proceeds from investment or business real estate into like-kind real property.
What are the 1031 exchange deadlines?
You must identify replacement property within 45 days of the sale and close within 180 days or by your tax return due date, including extensions, whichever is earlier.
Can I do a 1031 exchange on my home?
Generally no. Your primary residence does not qualify, though the separate home sale exclusion may apply. Rental and investment properties can qualify.
What is boot in a 1031 exchange?
Boot is cash or other non-like-kind value you receive, including debt relief. It is generally taxable up to the amount of your gain.
Do I need a qualified intermediary?
For most delayed exchanges, yes. The intermediary holds the sale proceeds so you never have constructive receipt of the funds.
This article is for general informational purposes only and is not legal, medical, tax, or financial advice. Rules vary by state and change over time; confirm details with the relevant agency or a licensed professional.
