How 1031 Real Estate Transactions Work

A 1031 exchange, named after its section in the Internal Revenue Code, allows for the deferral of capital gains taxes on the sale of a business or investment property. An investor can postpone paying tax on the profit by reinvesting the sale proceeds into a new, similar property, which is available for real estate held for investment or business use. This is a tax deferral, not permanent tax avoidance, as the tax obligation is rolled over to the new property.

This process can be repeated multiple times, with the accumulated deferred tax becoming due only when an investor sells a property for cash without reinvesting. The primary benefit is using the full proceeds for the next acquisition without an immediate reduction of capital from taxes.

Qualifying for a Tax-Deferred Exchange

To qualify for a 1031 exchange, properties must meet two standards. The first is the “like-kind” requirement, which for real estate means the properties must be of the same nature or character, even if they differ in quality. This allows for exchanges such as trading undeveloped land for an office building. Both the property being sold, the relinquished property, and the one being acquired, the replacement property, must be real estate located within the United States.

The second requirement is that both properties must be “held for investment or for productive use in a trade or business.” This excludes a personal primary residence or a property intended for immediate resale. For a vacation home to qualify, it must have been owned for at least 24 months before the exchange.

In each of the two 12-month periods within those 24 months, it must be rented at fair market value for at least 14 days, and the owner’s personal use cannot exceed the greater of 14 days or 10% of the days it was rented. These same rules apply to a replacement property acquired in an exchange. While no minimum holding period is specified for other investment properties, investors must demonstrate intent to hold them for business or investment.

Core Exchange Rules and Timelines

A 1031 exchange requires adherence to two strict deadlines that begin when the original property sale closes: the 45-Day Identification Period and the 180-Day Exchange Period. These two timeframes run concurrently, starting on the date the relinquished property is transferred. During the first 45 calendar days, the investor must formally identify potential replacement properties. This identification must be in writing, signed by the investor, and delivered to the party facilitating the exchange, providing a specific address or legal description.

Investors must use one of three rules for identification. The “three-property rule” allows identifying up to three potential replacement properties, regardless of their fair market value. The “200% rule” permits identifying any number of properties if their total fair market value does not exceed 200% of the relinquished property’s value. The “95% rule” allows an investor to identify more properties but requires them to acquire at least 95% of the total fair market value of all properties identified.

Failure to submit the written identification within this 45-day window disqualifies the transaction from tax-deferred status. The investor must acquire the replacement property within 180 days of the sale, or by the due date of their tax return for that year, whichever is earlier. These deadlines are absolute and are not extended for weekends or holidays.

The Role of the Qualified Intermediary

A Qualified Intermediary (QI) is required for nearly every deferred 1031 exchange to ensure the investor does not have actual or constructive receipt of the sale proceeds. If an investor takes control of the cash from the sale, the funds become taxable and invalidate the exchange. The QI is an independent party that prevents this by holding the funds.

The QI cannot be the investor or a “disqualified person,” which includes the investor’s agent, such as their real estate agent, accountant, or attorney, as well as certain relatives. The QI and investor enter into a written agreement before the closing of the first sale to manage the exchange funds.

Once the relinquished property is sold, the proceeds are paid directly to the QI. The QI then uses these funds to acquire the replacement property on the investor’s behalf and transfers the title to them to complete the exchange.

The Exchange Process Step-by-Step

The first step in the exchange process is to engage a Qualified Intermediary and enter into a formal exchange agreement before the sale of the current property closes. With the QI in place, the sale of the relinquished property can proceed. At closing, the funds are transferred directly from the buyer to the QI to avoid the investor’s constructive receipt of the proceeds.

Next, the investor must formally identify potential replacement properties. Within 45 days of the closing, the investor delivers a signed, written list of properties to the QI that adheres to one of the established identification rules.

Finally, the investor enters into a purchase agreement for a new property from the list. The QI uses the held funds to purchase the replacement property, and the title is transferred to the investor, completing the process within the 180-day exchange period.

Tax Reporting Requirements

A completed 1031 exchange must be reported to the IRS by filing Form 8824, “Like-Kind Exchanges,” with the investor’s federal income tax return for the tax year the exchange was initiated. Form 8824 requires descriptions of both the relinquished and the replacement properties, including their addresses. It also requires the dates when the property was transferred, identified, and received to confirm compliance with the exchange timelines.

The form is used to calculate any recognized gain and the basis of the new property. If the investor received any non-like-kind property or cash (known as “boot”), that portion of the gain is taxable in the current year and must be calculated on the form. The form also asks about the relationship between the investor and the other parties to the exchange.