1031 Like-Kind Exchange Example: Key Steps and Rules Explained

A 1031 like-kind exchange allows real estate investors to defer capital gains taxes when selling a property and reinvesting the proceeds into another qualifying property. This tax-deferral strategy helps investors grow their portfolios more efficiently by keeping more capital invested rather than paying immediate taxes on profits.

Understanding how a 1031 exchange works is essential because strict IRS rules govern eligibility, timelines, and documentation. Missing deadlines or misinterpreting requirements can result in unexpected tax liabilities.

Eligibility Factors

To qualify for tax deferral, both the relinquished and replacement properties must be held for investment or business purposes. Personal residences or vacation homes do not qualify unless converted into rental properties and held for a sufficient period. Misclassifying a property’s use can lead to disqualification and immediate tax liability.

The IRS defines “like-kind” broadly, meaning properties must be similar in nature or character, even if they differ in quality or use. An apartment building can be exchanged for a retail center, but not for stocks, bonds, or other non-real estate assets. Properties held for resale, such as fix-and-flip projects, do not qualify since they are considered inventory rather than investments.

Ownership structure matters. The same taxpayer who sells the relinquished property must acquire the replacement property. If an individual owns the property, the replacement must be in that individual’s name. If a partnership or LLC holds the property, special considerations apply, particularly if some partners wish to cash out while others reinvest. A drop-and-swap strategy may be used in such cases, but it must be structured carefully to avoid IRS scrutiny.

Debt and equity must be properly balanced. If the replacement property has a lower value or less debt than the relinquished property, the difference—known as “boot”—is taxable. For example, if an investor sells a property for $1 million with a $500,000 mortgage and acquires a replacement for $900,000 with a $400,000 mortgage, the $100,000 difference is subject to capital gains tax. To fully defer taxes, all proceeds must be reinvested, and the new debt level must match or exceed the previous one.

Types of Real Estate

A 1031 exchange applies to various types of real estate, provided they are held for investment or business purposes. The broad definition of like-kind allows investors to exchange different categories of real estate, as long as they meet IRS requirements.

Commercial

Commercial properties, such as office buildings, retail centers, warehouses, and industrial facilities, are commonly used in 1031 exchanges. Investors use this strategy to upgrade to larger properties, diversify holdings, or enter new markets. An investor who owns a $2 million strip mall may exchange it for a $3 million shopping center, provided all proceeds are reinvested and debt levels are maintained to avoid taxable boot.

Depreciation recapture is a key consideration. If a property has been depreciated over time, the IRS may require taxes on the recaptured depreciation if the exchange is not structured properly. Under Section 1250 of the Internal Revenue Code, depreciation recapture on commercial real estate is taxed at a maximum rate of 25%. A properly executed 1031 exchange defers this tax, preserving more capital for reinvestment.

Residential

Investment residential properties, such as rental homes, apartment buildings, and multifamily units, qualify for a 1031 exchange. Personal residences do not, unless converted into rentals and held for a sufficient period. While the IRS does not specify a minimum holding period, many tax professionals recommend at least one to two years to demonstrate investment intent.

A common strategy involves exchanging a single-family rental home for a multifamily property to increase rental income and diversify risk. For example, an investor selling a $500,000 rental home could exchange it for a $700,000 four-unit apartment building, using additional financing to cover the difference. This approach enhances cash flow and long-term appreciation potential while deferring capital gains taxes.

If a property was previously a primary residence but later converted into a rental, special rules apply. Under IRS Revenue Procedure 2008-16, the property must have been rented for at least 24 months before the exchange, with limited personal use during that period.

Land

Vacant land held for investment qualifies for a 1031 exchange, even if it does not generate income. Investors often use this strategy to consolidate parcels, acquire land in a more desirable location, or transition into income-producing real estate. An investor selling a 10-acre undeveloped lot for $1 million could exchange it for a commercial property of equal or greater value, deferring capital gains taxes.

Unlike buildings, land is not depreciable, so investors do not have to worry about depreciation recapture. However, if the land is later developed, the new structures will be subject to depreciation rules, which could impact future tax liabilities.

It is also important to distinguish between investment land and dealer property. Land held for resale, such as lots owned by a developer, does not qualify for a 1031 exchange because it is considered inventory rather than an investment asset. The IRS closely examines transactions involving frequent land sales to determine whether the property was held for investment or resale.

Sample Transaction Steps

Executing a 1031 exchange requires careful planning to ensure compliance with IRS regulations. The process begins with the decision to sell an investment property while deferring capital gains taxes. Before listing the property, an investor must engage a Qualified Intermediary (QI), a neutral third party responsible for holding the sale proceeds and facilitating the exchange. The IRS mandates that sellers cannot take possession of the funds at any point. Selecting a reputable QI ensures proper handling of escrowed funds and preparation of legal documents.

Once a buyer is secured and a purchase agreement is signed, the QI structures the transaction. The sale proceeds are wired directly into an escrow account controlled by the QI. The investor must then provide written instructions to the intermediary, outlining their intent to complete a 1031 exchange. The QI issues an exchange agreement and a replacement property identification form, which must be completed within the IRS-mandated timeframe.

Securing financing for the replacement property can be challenging, as lenders scrutinize 1031 exchange transactions closely due to strict timelines. Investors should work with financial institutions familiar with these exchanges to avoid delays. If additional capital is required, structuring the loan correctly ensures compliance with IRS debt replacement rules. Any shortfall in reinvestment could result in taxable income. The purchase agreement for the replacement property must include language acknowledging the 1031 exchange.

Identification and Closing Deadlines

The IRS imposes two key deadlines: the identification period and the exchange completion deadline. The identification window lasts 45 days from the sale of the relinquished property, requiring the investor to formally designate potential replacement properties in writing to the Qualified Intermediary. Failing to submit a valid identification list within this period disqualifies the exchange, triggering immediate taxation on any capital gains.

Investors may identify up to three properties without restriction under the Three-Property Rule. If more than three properties are listed, the total fair market value cannot exceed 200% of the relinquished property’s sale price under the 200% Rule. Alternatively, the 95% Rule allows an investor to identify an unlimited number of properties, provided they acquire at least 95% of the total value identified.

The closing deadline extends to 180 days from the sale of the relinquished property. If the investor’s tax return due date arrives before the 180th day, the exchange must be completed before filing unless an extension is obtained.

Document Preparation

Proper documentation ensures compliance with IRS regulations. Investors must work closely with their Qualified Intermediary and legal or tax advisors to ensure all required documents are correctly prepared and submitted.

The Exchange Agreement outlines the terms of the transaction and confirms that the investor intends to complete a 1031 exchange. This contract must be executed before the sale of the relinquished property. An Assignment of Rights document transfers the investor’s rights in the purchase and sale agreements to the Qualified Intermediary, ensuring the investor does not take constructive receipt of the funds.

Once the replacement property is identified, a formal Identification Notice must be submitted to the intermediary within the 45-day window. At closing, the investor must execute a Replacement Property Purchase Agreement, which should reference the 1031 exchange. Finally, IRS Form 8824 must be filed with the investor’s tax return, detailing the properties involved and confirming compliance with exchange rules.