How Does the 1031 Exchange Option Work?

A 1031 exchange, named after its section in the Internal Revenue Code, is a tax-deferral strategy for real estate investors. It allows an investor to postpone paying capital gains tax on the sale of a business or investment property by reinvesting the proceeds into a new, similar property. By deferring the tax, investors can use the full sale proceeds to acquire a more valuable property, allowing the capital to compound over time. The tax is not eliminated but is instead deferred until the replacement property is eventually sold.

Qualifying for a 1031 Exchange

For a 1031 exchange, both the property sold and the one acquired must meet IRS criteria. The properties must be “like-kind,” which refers to their nature or character, not their grade or quality. For instance, an apartment building can be exchanged for raw land, as both are considered real estate.

Both the relinquished and replacement properties must also have been held for productive use in a trade, business, or for investment. A taxpayer’s primary residence or a property intended for immediate resale, such as a house flip, does not qualify. Since the Tax Cuts and Jobs Act of 2017, 1031 exchanges apply only to real property, excluding assets like stocks, bonds, or partnership interests.

For a complete tax deferral, the replacement property’s purchase price must be equal to or greater than the relinquished property’s net selling price. The investor must also reinvest all net equity from the sale into the new property, otherwise a partial tax liability may be incurred.

Key Deadlines and Identification Rules

The 1031 exchange process is governed by strict timelines that begin when the original property sale closes. The first is the 45-Day Identification Period. Within 45 calendar days of the closing, the investor must identify potential replacement properties in a signed, written document delivered to the Qualified Intermediary.

The second deadline is the 180-Day Exchange Period. The investor has 180 calendar days from the original closing date to complete the purchase of an identified property. These two periods run concurrently, meaning the investor has 135 days to close after the 45-day identification window ends.

To identify properties, investors must follow one of three rules. The 3-Property Rule allows identifying up to three properties regardless of their value. The 200% Rule allows identifying any number of properties, provided their total value does not exceed 200% of the relinquished property’s value. The 95% Rule allows identifying properties that exceed the 200% limit, but the investor must then acquire at least 95% of the total value of all properties identified.

The Role of the Qualified Intermediary

In nearly all deferred 1031 exchanges, using a Qualified Intermediary (QI) is required. A QI is an independent third party who facilitates the exchange to ensure compliance with IRS regulations. The primary reason for a QI is to avoid “constructive receipt” of the sale proceeds by the taxpayer. If an investor controls the cash from the sale, even briefly, the transaction is disqualified and the gain becomes immediately taxable.

The QI holds the funds from the sale of the relinquished property in a secure account. When the investor is ready to close on the replacement property, they instruct the QI to wire the funds directly to the closing agent. This structure provides a safe harbor recognized by the IRS.

Choosing a reputable QI is an important step. Investors should verify an intermediary’s credentials, insurance, and security protocols. Fees for a QI can range from several hundred to over a thousand dollars, depending on the transaction’s complexity.

The Exchange Process Step-by-Step

The exchange process follows a clear sequence of actions for the investor. It is important to engage a Qualified Intermediary before the closing of the property being sold, as the exchange agreement must be in place prior to the sale. Once the relinquished property is sold, the closing agent sends the proceeds directly to the QI.

The investor then completes the following steps:

• Prepare a written, signed identification notice of potential replacement properties and deliver it to the QI no later than midnight on the 45th day after the sale.
• Negotiate and enter into a purchase agreement for a successfully identified replacement property.
• Manage all due diligence and contractual obligations for the new property as in a standard purchase.
• Instruct the QI to forward the exchange funds to the closing agent to acquire the replacement property before the 180-day deadline expires.

Once the title is transferred to the investor, the 1031 exchange is complete.

Tax Reporting and Basis Calculation

A successful 1031 exchange must be reported to the IRS on Form 8824, Like-Kind Exchanges, which is filed with the investor’s federal income tax return for the year of the exchange. This form requires a description of the properties, relevant dates, and a calculation of the deferred gain.

The basis of the relinquished property is carried over to the replacement property. The formula is the purchase price of the new property minus the gain deferred from the sale of the old property.

For example, an investor sells a property for $500,000 that had a $200,000 adjusted basis, resulting in a $300,000 capital gain. They then acquire a new property for $700,000. The new property’s basis would be its $700,000 purchase price minus the $300,000 deferred gain, which equals $400,000.

This adjusted basis is used for future depreciation deductions. When the replacement property is eventually sold in a taxable transaction, the deferred gain from the original exchange will be recognized, plus any new appreciation.