1031 Regulations for a Like-Kind Exchange

A like-kind exchange, governed by Section 1031 of the Internal Revenue Code, is a tax-deferral strategy for owners of business and investment real estate. It allows an owner to postpone paying capital gains tax on a property’s sale by reinvesting the proceeds into a new, similar property. This transaction is a deferral, not a permanent forgiveness of tax. The original tax liability is carried over to the new property and becomes due when that property is sold without another exchange.

Eligible Property for a Tax-Deferred Exchange

Following the Tax Cuts and Jobs Act of 2017, Section 1031 exchanges are limited exclusively to real property. The benefit is reserved for real estate held for productive use in a trade or business or for investment, such as commercial buildings, rental properties, and raw land.

The term “like-kind” refers to the nature of the property, not its quality. For example, an apartment building can be exchanged for a vacant lot. Both the relinquished property (the one sold) and the replacement property (the one acquired) must be held for business or investment purposes.

Certain types of real estate are explicitly excluded from qualifying for a 1031 exchange. Property held primarily for resale, such as a house “flipped” by a developer, does not qualify because it is considered inventory. A taxpayer’s primary residence is ineligible, as are partnership interests, stocks, bonds, and notes.

Vacation homes may qualify under a safe harbor provided by Revenue Procedure 2008-16. To be treated as an investment property, it must be rented at fair market value for at least 14 days annually. The owner’s personal use must not exceed the greater of 14 days or 10% of the days it was rented, with these conditions applying for the two years before and after the exchange.

The Mandated Role of a Qualified Intermediary

The use of a Qualified Intermediary (QI) is a requirement for most deferred exchanges. The QI is a neutral third party who facilitates the transaction to ensure the taxpayer does not have “constructive receipt” of funds. If a taxpayer controls the cash proceeds from the sale, the exchange is disqualified, and the gain becomes immediately taxable.

The QI’s function is to hold the sale proceeds after the relinquished property is sold and use these funds to acquire the replacement property for the taxpayer. This structure prevents the taxpayer from having direct access to the money, preserving the tax-deferred status. The QI also prepares the legal documents formalizing the exchange agreement.

A “disqualified person” cannot act as a QI. This includes the taxpayer’s agent, such as their employee, attorney, accountant, or real estate broker, if they provided services to the taxpayer within the prior two years. Family members are also disqualified.

A reputable QI handles the funds and documentation and guides the taxpayer through the timelines and rules. They help ensure all regulatory requirements are met to safeguard the transaction from disqualification.

The Strict Exchange Timelines

A 1031 exchange has two deadlines that begin when the relinquished property sale closes and run concurrently. The IRS does not grant extensions except for presidentially declared disasters.

The 45-Day Identification Period

Within 45 calendar days of closing the sale on the relinquished property, the taxpayer must formally identify potential replacement properties in writing. This signed identification must be delivered to the QI or another non-disqualified party to the exchange. The property description must be unambiguous, using a legal description or street address.

The regulations offer three rules for identifying properties. The “Three-Property Rule” allows the taxpayer to identify up to three potential replacement properties without regard to their fair market value. The taxpayer can then acquire one or more of these properties.

The “200% Rule” permits identifying any number of properties, as long as their total value does not exceed 200% of the relinquished property’s value. The “95% Rule” allows identifying unlimited properties, but the taxpayer must acquire properties worth at least 95% of the total value of all identified properties.

The 180-Day Exchange Period

The taxpayer must receive the replacement property and complete the exchange within 180 calendar days of the relinquished property’s transfer. This period is shortened if the taxpayer’s income tax return due date for the year of the sale falls before the 180-day mark. In that case, the exchange must be completed by the tax return due date, unless a filing extension is obtained.

The 180-day period includes the 45-day identification window; it is not an additional 180 days. For instance, if a property is identified on day 45, the taxpayer has 135 days left to close. Failing to acquire the property in this timeframe invalidates the exchange, making the capital gain taxable.

Calculating Taxable Proceeds

While the goal of a 1031 exchange is to defer 100% of the capital gains tax, this is only achieved if rules regarding the value and debt of the properties are followed. If a taxpayer receives property or cash that is not like-kind, it is considered “boot,” and its fair market value is taxable. The amount of gain recognized is the lesser of the total realized gain on the sale or the total boot received.

Cash Boot

Cash boot is any cash from the sale that is not reinvested into the replacement property. For example, if an investor sells a property for $500,000 and only uses $450,000 to purchase the replacement property, the remaining $50,000 is cash boot and is taxed. Boot can also include the value of any non-qualifying property received.

To avoid cash boot, the replacement property’s purchase price must be equal to or greater than the relinquished property’s net selling price. All net equity must be reinvested, as any cash the taxpayer takes from the exchange will be taxed.

Mortgage Boot (Debt Relief)

Mortgage boot, or debt relief, occurs when the debt on the replacement property is less than the debt paid off on the relinquished property. If a taxpayer sells a property with a $300,000 mortgage and acquires a new one with a $250,000 mortgage, the $50,000 difference is mortgage boot. This debt reduction is treated as taxable income unless offset.

A taxpayer can offset mortgage boot by adding an equivalent amount of cash to the purchase of the replacement property. The guiding principle is that the taxpayer must acquire a property with equal or greater debt or add cash to cover any debt shortfall.

Information Required for IRS Reporting

Taxpayers must report a like-kind exchange by filing Form 8824, Like-Kind Exchanges, with their federal income tax return for the year of the exchange. This form details the transaction, calculates the deferred gain, and establishes the new property’s basis.

Completing Form 8824 requires specific information for both properties. This includes a description of each property (address and type), the dates the properties were transferred, and the date the replacement property was identified.

The form requires financial details like contract prices, liabilities, and closing costs to calculate the realized gain and any boot received, which determines the recognized (taxable) gain. Form 8824 is also used to calculate the basis of the new property, which is its fair market value minus the deferred gain. Any relationship between the taxpayer and the other party to the exchange must also be disclosed.