What Are the Rules for a 1031 Exchange?

A 1031 exchange, named after Section 1031 of the Internal Revenue Code, is a tax-deferral strategy available to real estate investors. It allows an individual to postpone paying capital gains tax on the sale of a property by reinvesting the proceeds into a new property. The core principle is that the investor is not cashing out their investment but rather repositioning it. This is a tax deferral, not a permanent avoidance of tax liability, as the deferred gain will eventually be recognized when the final replacement property is sold in a taxable transaction.

Qualifying Property Requirements

The foundation of a 1031 exchange is the “like-kind” property rule. For real estate, this term is interpreted broadly by the IRS and refers to the property’s nature or character, not its grade or quality. This allows for a wide range of exchanges, such as swapping an apartment building for a parcel of raw land. Both the property being sold, the relinquished property, and the property being acquired, the replacement property, must be real property located within the United States.

Another requirement is that both properties must be “held for productive use in a trade or business or for investment.” This rule focuses on the taxpayer’s intent for owning the property, such as holding it to generate rental income or for capital appreciation. While not a statutory rule, a common guideline suggests holding a property for at least two years before an exchange to demonstrate investment intent.

This “held for” rule explicitly excludes certain types of property. A taxpayer’s primary residence is ineligible because it is held for personal use. Other excluded assets are stocks, bonds, notes, interests in a partnership, and property held primarily for resale, such as inventory for a real estate developer.

Critical Timelines and Identification Rules

The 1031 exchange process has deadlines that begin when the sale of the relinquished property closes. From this date, the taxpayer has a 45-Day Identification Period to formally identify potential replacement properties. The identification must be a written, signed document delivered to the exchange facilitator that unambiguously describes the property, for instance, by its legal description or street address.

A 180-Day Exchange Period also commences from the closing date of the relinquished property. The taxpayer must acquire and close on one or more of the identified replacement properties within this 180-day timeframe. This period includes the initial 45 days; it is not 45 days plus an additional 180. The only potential shortening of this period occurs if the taxpayer’s tax return for the year of the sale is due before the 180th day, in which case the deadline becomes the due date of the return.

The IRS provides three rules for identifying replacement properties, and the taxpayer must adhere to one. The Three-Property Rule allows the identification of up to three properties of any fair market value. An alternative is the 200% Rule, which permits identifying any number of properties if their total fair market value does not exceed 200% of the relinquished property’s value. The 95% Rule allows for identifying unlimited properties, but requires the taxpayer to acquire properties worth at least 95% of the total value of all properties identified.

The Role of the Qualified Intermediary

A rule in nearly every 1031 exchange is the use of a Qualified Intermediary (QI), sometimes called an accommodator. The QI is necessary because of the legal concept of “constructive receipt.” To qualify for tax deferral, the taxpayer cannot have actual or constructive receipt of the sales proceeds from the relinquished property; if the investor takes control of the funds, even for a moment, the IRS considers it a taxable sale.

The QI acts as an independent third party to prevent constructive receipt. Before the closing of the relinquished property, the taxpayer enters into an exchange agreement with the QI, who then holds the proceeds from the sale in a secure escrow account. The QI uses the held funds to acquire the chosen replacement property and transfer its title to the taxpayer to complete the exchange.

Treasury Regulations specify who is disqualified from acting as a QI to ensure their independence. A person is disqualified if they have been the taxpayer’s agent within the two-year period preceding the exchange, including their:

• Employee
• Attorney
• Accountant
• Investment banker
• Real estate agent

This restriction prevents conflicts of interest and reinforces the intermediary’s role as a neutral holder of the funds.

Understanding Taxable Boot

For an exchange to be completely tax-free, the replacement property’s value must be equal to or greater than the relinquished property’s value, and all equity must be reinvested. Any value received by the taxpayer that is not like-kind property is considered “boot” and is taxable. Boot arises when the investor does not fully reinvest the proceeds or acquires a property with less debt.

The most straightforward type of boot is “cash boot.” This occurs when the taxpayer receives cash from the exchange proceeds. For example, if an investor sells a property for $700,000 and buys a replacement property for $650,000, the $50,000 in cash they receive is boot and is subject to capital gains tax.

A more complex form is “mortgage boot,” also known as debt relief. This happens when the debt on the replacement property is less than the debt that was on the relinquished property. For instance, if an investor had a $300,000 mortgage on the sold property but only takes on a $250,000 mortgage for the new one, the $50,000 difference in debt is treated as taxable boot. An investor can offset this mortgage boot by adding an equivalent amount of their own cash to the purchase.

Reporting the Exchange to the IRS

After completing a 1031 exchange, the transaction must be reported to the IRS on Form 8824, Like-Kind Exchanges. This form is a required component of the taxpayer’s federal income tax return for the tax year in which the exchange was initiated, meaning the year the relinquished property was sold.

Part I of the form requires information about the like-kind properties, including detailed descriptions of both the relinquished and replacement assets. It also requires the dates the properties were identified and acquired, which allows the IRS to verify adherence to the 45-day and 180-day timelines.

Part III of the form is where the financial calculations take place. The taxpayer calculates the total gain realized on the sale of the relinquished property and then calculates any recognized gain, which is the portion of the gain that is taxable due to the receipt of boot. The form also determines the deferred gain and establishes the new cost basis for the replacement property for future tax calculations.