Sec 1031 Like-Kind Exchange: What Are the Rules?

A like-kind exchange, governed by Section 1031 of the Internal Revenue Code, is a tax-deferral strategy that allows a real estate investor to sell a property and reinvest the proceeds into a new one without immediately paying capital gains tax. Because the transaction is treated as an exchange rather than a sale, the tax liability is postponed. The investor is considered to be continuing their investment from one property into another.

This tax deferral postpones the tax obligation until the replacement property is sold in a taxable transaction. This allows investors to transition between properties, upgrade, or diversify their portfolio without an immediate reduction of capital from taxes, facilitating the reallocation of investment capital.

Qualifying for a Tax-Deferred Exchange

To qualify for a tax-deferred exchange, both the relinquished property (the one sold) and the replacement property (the one acquired) must be held for productive use in a trade or business or for investment. This is known as the “qualified use” test. Property held for personal use, such as a primary residence or a vacation home, is disqualified from this tax treatment.

Property acquired with the intention of being resold, such as houses “flipped” by developers, is considered inventory and does not meet the qualified use standard. The taxpayer’s intent is a factor, as the IRS looks for a clear intention to hold the property for business or investment purposes, not short-term speculation.

Another requirement is that the exchanged properties must be “like-kind.” For real estate, this term is interpreted broadly. An apartment building can be exchanged for raw land, or a retail center for a single-family rental, as long as both are real property held for business or investment.

This flexibility allows investors to shift strategies, such as moving from residential to commercial properties. The Tax Cuts and Jobs Act of 2017 limited these exchanges to real property, eliminating assets like machinery or equipment. Additionally, real property in the United States is not considered like-kind to property located outside the U.S.

Key Exchange Rules and Timelines

Completing a like-kind exchange requires adherence to two deadlines. The first is the 45-day identification period, which begins the day after the relinquished property sale closes. Within this window, the taxpayer 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 taxpayer must acquire the replacement property within 180 days of the relinquished property’s closing. This period runs concurrently with the 45-day identification period, and the exchange must be finished by the 180-day mark or the tax return due date for that year, whichever is earlier.

The IRS provides three methods for identifying replacement properties, and the taxpayer must use one. The “Three-Property Rule” allows the identification of up to three potential properties regardless of their fair market value, providing options if a deal falls through.

The “200% Rule” allows a taxpayer to identify any number of properties, provided their combined fair market value does not exceed 200% of the relinquished property’s value.

The “95% Rule” allows for identifying any number of properties with no value limit, but the taxpayer must ultimately acquire at least 95% of the total fair market value of all properties identified.

Understanding Exchange Proceeds and Boot

If a taxpayer receives cash or other property that is not like-kind during an exchange, it is referred to as “boot.” Receiving boot does not invalidate the exchange, but the value of the boot received is subject to capital gains tax.

Cash boot occurs when the taxpayer receives cash from the sale proceeds instead of having the full amount reinvested. Any cash taken from the exchange, either for personal use or to pay for non-qualified closing expenses, is taxable up to the amount of the gain.

Mortgage boot, or debt relief, occurs when the debt on the replacement property is less than the debt on the relinquished property. For instance, if the mortgage on the new property is $50,000 less than the old one, that $50,000 is taxable boot. This can be offset by adding an equivalent amount of cash to the purchase.

To fully defer the tax, the replacement property’s value and equity must be equal to or greater than the relinquished property’s. If these conditions are not met, boot is often created. The taxable gain is the lesser of the total realized gain on the sale or the total amount of boot received.

The Exchange Process and Required Parties

A like-kind exchange requires the use of a Qualified Intermediary (QI) to prevent the taxpayer from having actual or constructive receipt of sale proceeds. The QI is an independent entity that holds the funds from the sale of the relinquished property. The QI then uses these funds to acquire the replacement property for the investor.

Before the relinquished property is sold, the taxpayer must enter into a formal exchange agreement with a QI. At closing, the sale proceeds are sent directly to the QI to be held in a secure account. The taxpayer never has control over these funds.

After the sale, the taxpayer identifies potential replacement properties and delivers the list to the QI. Once a property is under contract, the taxpayer assigns their rights in the purchase agreement to the QI. The QI uses the exchange funds to purchase the property and directs the title to be transferred to the taxpayer, completing the exchange.

Tax Reporting and Basis Calculation

A completed exchange must be reported to the IRS on Form 8824, “Like-Kind Exchanges.” This form is filed with the federal income tax return for the year the relinquished property was sold. It details the properties, transaction dates, and calculations for any recognized gain and the new property’s basis.

In a tax-deferred exchange, the tax basis of the relinquished property is carried over to the replacement property. This preserves the deferred gain within the new property’s basis.

To calculate the new property’s adjusted basis, subtract the deferred gain from its purchase price. For example, if a replacement property is purchased for $800,000 and the deferred gain was $300,000, the new adjusted basis is $500,000. Future depreciation deductions will be calculated from this reduced amount.