How to Do a 1031 Exchange: A Step-by-Step Process

A 1031 exchange, also known as a like-kind exchange, offers a strategy for investors seeking to defer capital gains taxes when selling investment property. This provision allows for the reinvestment of sale proceeds from one qualifying property into another “like-kind” property, without immediately recognizing taxable gain. Investors can effectively roll over their investment, preserving capital for continued growth.

Key Requirements for a Valid Exchange

A successful 1031 exchange requires meeting several requirements before any property sale occurs. Both the property being sold, known as the relinquished property, and the property being acquired, the replacement property, must be considered “like-kind” real property. This term refers to the nature or character of the property, not its grade or quality. For example, a vacant lot can be exchanged for an apartment building, or a commercial office for raw land, as long as both are real estate. Certain properties are excluded, such as a primary residence, property held primarily for sale, stocks, bonds, notes, securities, or partnership interests.

Both the relinquished and replacement properties must be held for productive use in a trade or business or for investment purposes. Properties intended for personal use or quick resale do not qualify. The intent behind holding the property is paramount, focusing on generating income, appreciation, or business utility rather than personal enjoyment.

A Qualified Intermediary (QI), sometimes referred to as an Exchange Accommodator, plays an important role in most deferred 1031 exchanges. The IRS mandates the use of a QI to prevent the taxpayer from having actual or constructive receipt of the sale proceeds from the relinquished property. Without a QI, directly receiving funds would immediately trigger a taxable event, disqualifying the exchange. The QI acts as a neutral third party, holding the funds in trust and facilitating the exchange to ensure compliance with IRS regulations.

Most exchanges are structured as “deferred exchanges,” meaning the sale of the relinquished property and the acquisition of the replacement property do not happen simultaneously. This structure provides flexibility but introduces strict timelines that must be followed. The QI guides the process to meet these regulatory requirements.

The Relinquished Property Sale

Initiating a 1031 exchange begins with the sale of the relinquished property, but groundwork must be laid before closing. Engage a Qualified Intermediary (QI) and establish an Exchange Agreement with them prior to the actual sale. This agreement outlines the QI’s role in facilitating the tax-deferred exchange and their responsibility for holding the sale proceeds.

The sale contract for the relinquished property must include language indicating the seller’s intent to perform a 1031 exchange. This ensures the transaction is structured correctly from a legal and tax perspective. Documenting this intent prevents the taxpayer from being deemed in constructive receipt of funds.

At the closing of the relinquished property, the sale proceeds are not disbursed directly to the taxpayer. Instead, the funds are transferred directly from the buyer to the Qualified Intermediary, who holds them in a segregated exchange account. This step is essential to maintaining the tax-deferred status of the exchange. The QI ensures the funds are secure and available for the subsequent acquisition of the replacement property.

Documentation is essential throughout this stage, including the executed Exchange Agreement and closing statements that show the transfer of funds to the QI. The QI prepares these documents, ensuring they align with IRS requirements. This record-keeping provides a clear audit trail and demonstrates adherence to all procedural rules for a valid exchange.

Identifying and Acquiring Replacement Property

After the sale of the relinquished property, the investor enters a period governed by strict deadlines for identifying and acquiring replacement property. The first is the 45-day identification period, which begins on the closing date of the relinquished property sale. Within this timeframe, the investor must identify potential replacement properties in writing.

The identification notice must clearly describe each property by street address or legal description, and be delivered to the Qualified Intermediary (QI). The IRS provides rules for how many properties can be identified:
The Three Property Rule allows for identification of up to three properties of any value.
The 200% Rule permits identifying any number of properties, provided their aggregate fair market value does not exceed 200% of the relinquished property’s value.
The 95% Rule applies if more properties are identified or the 200% rule is exceeded, requiring the acquisition of at least 95% of the aggregate value of all identified properties.
Failure to adhere to these identification rules or deadlines can result in the disqualification of the entire exchange.

The second deadline is the 180-day exchange period, which runs concurrently with the 45-day identification period. The investor must acquire the identified replacement property within 180 calendar days from the date the relinquished property was sold, or by the due date (including extensions) of the investor’s tax return for the year of the sale, whichever comes first. If the 45-day period is fully utilized, only 135 days remain to complete the acquisition. These deadlines are absolute and are not extended, unless a federally declared disaster applies.

Acquiring the replacement property involves entering into a purchase agreement for one or more of the identified properties. The Qualified Intermediary then facilitates this purchase by utilizing the exchange funds held in trust. The QI directly transfers these funds to the seller of the replacement property. At the closing of the replacement property, the QI’s involvement ensures the transaction is properly documented as part of the ongoing 1031 exchange.

Reporting Your 1031 Exchange

Completing a 1031 exchange requires reporting to the IRS to recognize the tax deferral. Taxpayers must file IRS Form 8824, “Like-Kind Exchanges,” with their income tax return for the year in which the relinquished property was sold. This form provides details of both the property sold and the property acquired.

Form 8824 requires information about the exchange, including descriptions of both the relinquished and replacement properties, the dates of their transfer, and the amounts involved. This data helps the IRS verify that all requirements for a valid like-kind exchange were met. The basis of the relinquished property is carried over and adjusted to become the basis of the newly acquired replacement property. This adjusted basis impacts future depreciation deductions and the calculation of capital gains upon a subsequent sale of the replacement property.

Consulting with a qualified tax advisor is recommended for accurately reporting a 1031 exchange and adjusting the property’s basis. A tax professional can provide guidance on correctly completing Form 8824 and integrating the exchange details into the overall tax return. Ensuring accurate reporting is important to securing the tax deferral benefits of the 1031 exchange.