The Rules and Requirements for 1031s

A 1031 exchange, from Section 1031 of the U.S. Internal Revenue Code, allows real estate investors to postpone paying capital gains taxes on the sale of an investment property. This tax deferral is achieved by reinvesting the proceeds from the sale into a new, similar property, allowing gains to be rolled over from one investment to another.

Core Requirements for a Valid Exchange

To qualify for a 1031 exchange, the properties involved must be “like-kind.” For real estate, this is a broad definition, as most properties are considered like-kind to one another. For instance, an apartment building can be exchanged for raw land, or a retail center for a single-family rental. The properties must be of the same nature or character, even if their grade or quality differs.

Both the relinquished property (the one you sell) and the replacement property (the one you acquire) must be held for business or investment purposes. Personal residences, like a primary home or vacation house, are not eligible. While the IRS has not set a specific holding period, holding a property for at least one to two years is a widely accepted guideline to demonstrate investment intent. A two-year holding period is required for exchanges involving related parties.

To defer all capital gains tax, the investor must acquire a replacement property of equal or greater value than the one sold. Any cash received, debt relief, or other non-like-kind property is considered “boot” and is subject to taxation. For example, if the mortgage on the new property is less than the mortgage on the old property, the difference is treated as taxable income.

Essential Participants and Initial Documentation

Most 1031 exchanges require a Qualified Intermediary (QI). The QI is a neutral third party who holds the funds from the sale of the relinquished property and uses them to acquire the replacement property. This process is an IRS safe harbor that prevents the investor from having actual or constructive receipt of the sale proceeds. If the investor takes control of the funds, the transaction is disqualified and the gains become immediately taxable.

Before the exchange begins, the investor and the QI must execute a formal Exchange Agreement. This contract outlines the terms, conditions, and responsibilities of both parties. The agreement must be in place before the closing of the relinquished property sale.

The Exchange Process and Timelines

From the date the relinquished property sale closes, the investor has 45 calendar days to formally identify potential replacement properties. This identification must be in writing, signed by the investor, and delivered to the QI. Investors must follow one of three identification rules:

• The 3-Property Rule: Identify up to three properties of any value.
• The 200% Rule: Identify any number of properties as long as their combined fair market value does not exceed 200% of the relinquished property’s value.
• The 95% Rule: Identify any number of properties, provided the investor acquires properties worth at least 95% of the total value identified.

The investor must complete the acquisition of a replacement property within 180 calendar days from the closing of the relinquished property sale. The 45-day identification period and the 180-day exchange period run concurrently. This means if an investor identifies a property on day 45, they have 135 days remaining to close. The entire exchange must be completed within this 180-day window, or the transaction will fail and trigger the tax liability.

Tax Reporting for the Exchange

A completed 1031 exchange must be reported to the IRS on Form 8824, “Like-Kind Exchanges.” This form is attached to the investor’s federal income tax return for the tax year in which the relinquished property was sold.

Form 8824 requires descriptions of the relinquished and replacement properties, the dates they were identified and acquired, and the relationship between the parties to the exchange. The form also guides the calculation of the realized gain, the recognized gain from any boot, and the basis of the new property.