IRC 1031 Regulations for a Tax-Deferred Exchange

An Internal Revenue Code (IRC) Section 1031 exchange is a tax-deferral strategy for owners of certain property. It permits an investor to postpone paying capital gains taxes by reinvesting the proceeds from the sale of a business or investment property into a new, similar asset. This strategy allows for the deferral of federal capital gains, state income taxes, depreciation recapture taxes, and the net investment income tax. The tax deferral is not permanent and the taxes will be due when the final investment property is sold for cash.

Qualifying Property Requirements

Following the Tax Cuts and Jobs Act of 2017, this tax deferral is restricted exclusively to real property. Under Treasury Regulation T.D. 9935, real property includes land and inherently permanent structures and their components. This can also include certain intangible interests in real estate, such as leaseholds with more than 30 years remaining, perpetual water rights, and mineral interests.

The assets involved must also be “like-kind.” For real estate, this is a broad standard where properties are considered like-kind if they are of the same nature or character, even if their quality differs. An investor can exchange an apartment building for raw land or a commercial office for single-family rentals. Real property within the United States is not considered like-kind to real property outside the United States.

Both the property being sold (relinquished) and the property being acquired (replacement) must be held for productive use in a trade or business or for investment. Property held for personal use, such as a primary residence, does not qualify. Property held primarily for resale, like a developer’s inventory, is also excluded. An investor’s intent is a governing factor, and a property should be held for a sufficient period, suggested as two years under safe harbor guidance like Revenue Procedure 2008-16, to demonstrate proper intent.

The Exchange Timelines and Identification Rules

A successful 1031 exchange requires adherence to two strict deadlines that begin when the original property is sold. These timelines are absolute and are not extended for weekends or holidays, though exceptions may be granted for taxpayers affected by federally declared disasters.

The first deadline is the 45-Day Identification Period, where an investor has 45 calendar days from the closing date of the relinquished property to formally identify potential replacement properties. This identification must be a signed, written document delivered to the Qualified Intermediary or another non-disqualified party. The document must unambiguously describe the property with a specific address or legal description.

The second deadline is the 180-Day Exchange Period, which runs concurrently with the identification period. The investor must acquire the replacement property and complete the exchange within 180 calendar days of the original sale. This period ends on the 180th day or the due date of the tax return for the year the relinquished property was sold, whichever comes first.

Within the 45-day window, the taxpayer must follow one of three identification rules:

• The Three-Property Rule allows the investor to identify up to three potential replacement properties without regard to their fair market value.
• The 200% Rule permits identifying any number of properties, provided their total fair market value does not exceed 200% of the relinquished property’s value.
• The 95% Rule allows an investor to identify any number of properties of any value, but they must acquire at least 95% of the total fair market value of all properties identified.

The Role of the Qualified Intermediary and Handling of Funds

A core principle of a 1031 exchange is that the taxpayer cannot have actual or constructive receipt of the sale proceeds. To prevent this, regulations require the use of a Qualified Intermediary (QI), an independent third party who manages the exchange funds. The QI receives the proceeds from the sale, holds them securely, and then uses them to acquire the replacement property on the taxpayer’s behalf.

A “disqualified person” cannot act as the QI. This includes anyone who has acted as the taxpayer’s agent within the two years prior to the exchange, such as their employee, attorney, accountant, or real estate broker. This rule ensures the QI is independent and not subject to the taxpayer’s control.

A taxable event can occur if the investor receives non-like-kind property, known as “boot,” as part of the exchange. Cash boot is any portion of the sale proceeds the taxpayer receives directly. Mortgage boot, or debt relief, occurs if the mortgage on the replacement property is less than the mortgage on the relinquished property. For a fully tax-deferred exchange, the investor must acquire a property of equal or greater value and replace the debt on the old property with an equal amount of debt on the new one.

Structuring Complex Exchanges

Beyond a standard delayed exchange, more complex structures can accommodate different situations. A Reverse Exchange is used when an investor must acquire a replacement property before selling their existing one. This structure uses a third party, an Exchange Accommodation Titleholder (EAT), to take title to and “park” one of the properties.

In a typical Reverse Exchange, the EAT acquires the new replacement property. The investor then has 45 days to identify the relinquished property they will sell and the remainder of the 180-day period to complete the sale. This structure is more complex and costly than a standard exchange.

An Improvement or Construction Exchange is for investors who want to use exchange funds to improve or build on the replacement property. The EAT first acquires title to the replacement property, allowing exchange funds held by the QI to pay for construction costs. The investor must identify the property and planned improvements within 45 days, and all work must be finished before the 180-day period expires. For full tax deferral, the replacement property’s value upon transfer must be equal to or greater than the relinquished property’s value.

Reporting the Exchange to the IRS

A 1031 exchange must be reported to the IRS by filing Form 8824, Like-Kind Exchanges, with the federal income tax return for the year the exchange was initiated. This applies even if the replacement property was acquired in the following calendar year. Failure to file this form can disqualify the exchange and make any gains immediately taxable.

Completing Form 8824 requires detailed descriptions of the relinquished and replacement properties. It also requires key dates for the transaction to verify compliance with the 45-day and 180-day rules. The form uses this information to calculate the realized gain, the recognized (taxable) gain, and the deferred gain.

A calculation on the form determines the new property’s basis. The basis of the original property is carried over to the replacement property and adjusted for any additional cash paid or gain recognized. This adjusted basis is used to calculate the taxable gain when the replacement property is eventually sold.