What Are the Rules for a 1031 Exchange?

A 1031 exchange, named after Section 1031 of the Internal Revenue Code, allows for the deferral of capital gains taxes on the sale of certain properties. This mechanism enables investors to reinvest proceeds from a sale into a new property without immediately recognizing a gain. The principle is the continuous holding of investment or business-use real estate, allowing an investor to shift from one property to another while postponing tax consequences.

Qualifying for a 1031 Exchange

To be eligible for a 1031 exchange, both the property being sold, known as the relinquished property, and the one being acquired, the replacement property, must meet specific criteria. The primary requirement is that both properties must be held for productive use in a trade, business, or for investment. This explicitly excludes personal-use assets, such as a primary residence.

However, a vacation home may qualify under specific IRS safe harbor guidelines. For a relinquished property, it must have been owned for at least 24 months before the exchange. In each of the two 12-month periods in that timeframe, the property must have been rented at fair market value for 14 or more days, and the owner’s personal use cannot have exceeded the greater of 14 days or 10% of the days it was rented. Similar holding and use rules apply to a replacement property after it is acquired.

Under current law, 1031 exchanges are restricted to real property. The term “like-kind” is interpreted broadly for real estate, meaning the properties do not have to be identical. For instance, an investor can exchange an apartment building for undeveloped land or a retail center for an industrial warehouse. To be considered like-kind, both properties must be located within the United States; U.S. property cannot be exchanged for property in another country.

The “same taxpayer” rule requires that the entity selling the relinquished property must also acquire the replacement property. An exception applies to single-member LLCs, which the IRS treats as “disregarded entities.” This means the individual owner is considered the taxpayer, allowing an individual to sell a property and have their wholly-owned LLC acquire the replacement property.

The 1031 Exchange Process and Timeline

A 1031 exchange is governed by strict timelines, with the most common type being a deferred exchange. A Qualified Intermediary (QI) must be used to facilitate the transaction. To prevent the taxpayer from having “constructive receipt” of the sale proceeds, which would invalidate the exchange, the QI holds the funds from the sale and uses them to acquire the replacement property for the investor.

Once the relinquished property is sold, two deadlines begin. The first is the 45-day identification period, during which the investor must formally identify potential replacement properties in a signed written document delivered to the QI. An investor can identify up to three properties of any value under the “3-Property Rule.” Alternatively, 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 second deadline is the exchange period. The investor must close on the purchase of an identified replacement property by the earlier of two dates: 180 calendar days from the sale of the relinquished property, or the due date of their income tax return for that year. This period runs concurrently with the 45-day window, meaning the investor has 135 days remaining after the identification period ends. These deadlines are not extended for weekends or holidays.

Understanding Boot and Basis Adjustments

When an investor receives property that is not “like-kind” as part of the exchange, it is referred to as “boot.” Boot comes in two primary forms. “Cash boot” is any sale proceeds the investor receives and does not reinvest, while “mortgage boot” occurs if the debt on the replacement property is less than the debt on the relinquished property.

Receiving boot does not disqualify the exchange, but it does trigger a taxable event. The taxable gain is the lesser of the total gain realized on the sale or the total amount of boot received. For example, if an investor has a realized gain of $200,000 and receives $50,000 in cash boot, they must pay capital gains tax on that $50,000, while the remaining $150,000 of gain is deferred.

The tax basis from the old property is carried over to the new one with adjustments. A formula to calculate the new basis is the purchase price of the replacement property minus the gain that was deferred in the exchange. For instance, if a replacement property is purchased for $1 million and the deferred gain was $400,000, the new property’s adjusted basis is $600,000. This adjusted basis will be used to calculate depreciation and the taxable gain upon a future sale.

Reporting the Exchange to the IRS

All like-kind exchanges must be reported on IRS Form 8824, “Like-Kind Exchanges.” This form is filed with the taxpayer’s annual federal income tax return for the year in which the relinquished property was sold. Even if an exchange concludes in the next tax year, it is reported on the return for the year the sale occurred.

To complete Form 8824, the taxpayer must provide detailed descriptions of the relinquished and replacement properties. The following dates must also be provided:

• The date the relinquished property was originally acquired
• The date the relinquished property was transferred
• The date the replacement property was identified
• The date the replacement property was received

The form requires a financial breakdown of the exchange, including the fair market value of the properties, the adjusted basis of the property given up, and any liabilities transferred. This information is used to calculate the realized gain, boot received, recognized gain, deferred gain, and the basis of the new property.