What Is a 1031 Exchange and How Does It Work?

A 1031 exchange is a tax-deferral strategy available to real estate investors in the United States. Named after Section 1031 of the U.S. Internal Revenue Code, this provision allows an investor to sell a property held for business or investment purposes and reinvest the proceeds into a new, similar property without immediately paying capital gains taxes. By deferring the tax liability, investors can acquire more substantial replacement properties, diversify their portfolios, or shift into different types of real estate assets.

Qualifying for a 1031 Exchange

To execute a valid 1031 exchange, the transaction must adhere to several requirements established by the Internal Revenue Service (IRS).

• The properties must be “like-kind.” For real estate, this term is interpreted broadly, referring to the nature of the property rather than its quality. An investor can exchange an apartment building for vacant land or a retail center for a single-family rental, as long as both are real property.
• Both the sold property (relinquished) and the acquired property (replacement) must be held for investment or for productive use in a trade or business. This rule disqualifies personal residences and property held primarily for resale, such as a house “flip.”
• The transaction must satisfy the “same taxpayer” rule. This principle dictates that the party, whether an individual or a legal entity, that sells the relinquished property must be the same one that acquires the replacement property.
• Real property located within the United States can only be exchanged for other real property within the United States. Foreign real property can be exchanged for other foreign real property, but not for U.S. property.

The Exchange Timeline and Identification Rules

Completing a 1031 exchange hinges on adhering to two strict deadlines that begin the day after the relinquished property sale closes. These timelines are mandated by the IRS and offer no extensions, even for weekends or holidays. Failure to meet these deadlines will invalidate the exchange, making the entire capital gain from the sale immediately taxable.

The 45-Day Identification Period

The first deadline is the 45-day identification period. Within this timeframe, the investor must formally identify potential replacement properties. This identification must be in writing, signed by the investor, and delivered to the Qualified Intermediary (QI) facilitating the exchange. The description of the properties must be unambiguous, such as by providing the property address or legal description.

The 180-Day Exchange Period

The second deadline is the 180-day exchange period, which runs concurrently with the 45-day period. The investor must close on and acquire one or more of the identified replacement properties within 180 days of the original property’s sale date. The 180-day period is the total time allowed for the transaction and is not in addition to the 45-day period. If the deadline falls after the due date for the investor’s tax return, the investor must file for an extension to use the full 180 days.

Replacement Property Identification Rules

To properly identify potential replacement properties within the 45-day window, the investor must satisfy one of three specific rules.

• The Three-Property Rule: An investor can identify up to three properties of any fair market value. The investor only needs to acquire one of these properties to complete the exchange.
• The 200% Rule: An investor can identify more than three properties, provided their total fair market value does not exceed 200% of the fair market value of the relinquished property.
• The 95% Rule: An investor can identify an unlimited number of properties with no value restriction, but they must acquire properties that amount to at least 95% of the total value of all properties identified.

Key Concepts and Calculations

Navigating a 1031 exchange requires understanding several financial concepts and the involvement of a specific third party. The structure is designed to prevent the investor from having direct control over the sale proceeds, which is a component of the tax deferral.

Role of the Qualified Intermediary (QI)

The use of a Qualified Intermediary (QI) is a requirement for nearly all 1031 exchanges. A QI is an independent third party that facilitates the exchange by holding the proceeds from the sale of the relinquished property on behalf of the investor. This prevents the investor from having “constructive receipt” of the funds; if the investor were to receive the cash, the exchange would be disqualified and the gains would become taxable.

The QI prepares the necessary exchange documents, receives the funds from the closing of the relinquished property, and disburses those funds for the purchase of the replacement property. An investor cannot use their own agent, such as their real estate agent or attorney, if that person has provided services to them within the two years prior to the exchange. Fees for a standard delayed exchange range from $250 to $2,500, depending on the complexity of the transaction.

Understanding “Boot”

In a 1031 exchange, “boot” is any non-like-kind property received by the investor. Receiving boot does not disqualify the entire exchange, but the boot itself is taxable up to the amount of the total capital gain. There are two primary forms of boot.

Cash boot includes any sale proceeds that the investor receives directly or does not reinvest into the replacement property. Mortgage boot, or debt relief, occurs if the debt on the replacement property is less than the debt that was on the relinquished property. If an investor had a $300,000 mortgage on the old property but only a $250,000 mortgage on the new one without adding $50,000 in cash, the $50,000 reduction in debt is treated as taxable mortgage boot.

Calculating the New Property’s Basis

A 1031 exchange defers tax liability, it does not eliminate it. This deferral is managed by carrying over the adjusted basis of the relinquished property to the replacement property. The basis is the property’s value for tax purposes, starting with its original purchase price and adjusted for factors like capital improvements and depreciation.

To calculate the basis of the new property, you start with its purchase price and then subtract the gain that was deferred from the sale of the relinquished property. For example, assume an investor sells a property for $1 million that had an adjusted basis of $400,000, resulting in a $600,000 deferred gain. If they purchase a new property for $1.2 million, the basis of that new property would be $600,000 ($1.2 million purchase price minus the $600,000 deferred gain).

Reporting the Exchange to the IRS

After a 1031 exchange is completed, it must be reported to the IRS on the investor’s federal income tax return using Form 8824, “Like-Kind Exchanges.” This form must be filed for the tax year in which the relinquished property was sold. For example, if an investor sells a property in November 2024 and acquires the replacement in February 2025, the exchange is reported on the 2024 tax return.

The form requires information such as property descriptions, transaction dates, and values to calculate the deferred gain and the new basis of the replacement property. It is important to file Form 8824 because the settlement agent at the closing is required to file a Form 1099-S with the IRS, reporting the gross proceeds from the sale. Filing Form 8824 clarifies to the IRS that the transaction was part of a tax-deferred exchange.