What Is Not Allowed in a 1031 Exchange?

A 1031 exchange allows investors to defer capital gains taxes when trading one investment property for another. This tax-deferral strategy, outlined in Section 1031 of the Internal Revenue Code, enables real estate owners to reinvest proceeds into a “like-kind” property without immediately recognizing the gain. The Internal Revenue Service (IRS) imposes guidelines on what qualifies for this deferral. Understanding these limitations helps ensure an exchange meets the criteria and avoids unexpected tax liabilities.

Ineligible Property Types

Certain property types are excluded from 1031 exchange treatment. A taxpayer’s primary residence does not qualify, as it is personal-use property rather than an investment or business asset. Vacation homes typically do not qualify if their primary use is personal enjoyment.

Property held primarily for sale, such as inventory or dealer property, is ineligible for a 1031 exchange. This exclusion applies to real estate developers, house flippers, or others who acquire property for immediate resale rather than long-term investment or productive use in a trade or business.

Financial instruments, including stocks, bonds, notes, and other securities, are excluded from like-kind exchange treatment. This also extends to interests in a partnership and certificates of trust or beneficial interests. These assets are not considered like-kind to real property for 1031 exchange purposes.

Real property located outside the United States cannot be exchanged for real property within the United States. While foreign property can be exchanged for other foreign property, and U.S. property for other U.S. property, cross-border exchanges do not qualify. Only real property exchanges generally qualify for 1031 treatment, as personal property exchanges were eliminated by the Tax Cuts and Jobs Act of 2017.

Specific Requirements for Qualifying Property

For real property to be eligible for a 1031 exchange, it must meet specific criteria. Both the relinquished property (the one being sold) and the replacement property (the one being acquired) must be held for productive use in a trade or business or for investment purposes. This requirement distinguishes qualifying properties from those held for personal enjoyment or immediate resale.

Qualifying property includes rental properties, commercial buildings, raw land held for appreciation, and other real estate generating income or held for future investment growth. Property used primarily for personal use, such as a main home or a recreational vacation home, does not satisfy this “held for” requirement. The IRS evaluates the intent of holding the property by considering factors like rental income, depreciation claims, and duration of ownership.

The “like-kind” requirement for real property refers to its nature or character, not its grade or quality. A wide variety of real estate types can be exchanged. For instance, raw land can be exchanged for an apartment building, or a commercial property for a residential rental property, as long as both are real property held for productive use or investment. Real property in the United States is generally considered like-kind to other real property in the United States, regardless of its specific form or location within the country.

Non-Compliance with Exchange Procedures

A 1031 exchange can fail if specific procedural rules are not strictly followed. A common pitfall is failing to meet the identification period deadline. After selling the relinquished property, the taxpayer has a 45-calendar-day window to identify potential replacement properties. This identification must be made in writing and delivered to a party involved in the exchange, typically a Qualified Intermediary. Missing this deadline, or failing to properly identify properties (e.g., Three-Property Rule or 200% Rule), will disqualify the exchange.

Following the identification period, there is a 180-calendar-day exchange period to acquire the identified replacement property. This 180-day period runs concurrently with the 45-day identification period. If the full 45 days are used for identification, only 135 days remain for acquisition. Both deadlines are absolute and cannot be extended for weekends, holidays, or other delays, except in very limited circumstances like presidentially declared disasters.

Avoiding the constructive receipt of funds is a key procedural requirement for a delayed exchange. The taxpayer must not have direct or indirect control over the sale proceeds from the relinquished property at any point. To prevent constructive receipt, a Qualified Intermediary (QI) must hold the funds from the sale and use them to acquire the replacement property. If the taxpayer accesses the funds, the entire exchange may be disqualified, and the deferred gain becomes immediately taxable.

Elements Triggering Taxable Gain

Certain elements can trigger an immediate taxable gain within a 1031 exchange, preventing full tax deferral. This taxable portion is called “boot,” defined as any non-like-kind property received. While boot does not necessarily disqualify the entire exchange, it makes the transaction partially taxable to the extent of the boot received or the realized gain, whichever is lower.

Common forms of boot include cash received directly by the taxpayer or remaining after the exchange, or other non-like-kind assets like personal property or promissory notes. For example, if a taxpayer sells a property for $500,000 but only reinvests $400,000 into a replacement property, the remaining $100,000 is considered cash boot and becomes taxable. Any funds not reinvested are generally subject to tax.

Mortgage boot arises when the mortgage debt on the replacement property is less than on the relinquished property. This reduction in debt is treated as taxable boot because the taxpayer receives a financial benefit. To avoid mortgage boot, the new property should have equal or greater debt than the relinquished property, or any reduction must be offset by adding cash to the exchange.

Special rules apply to exchanges involving related parties, as defined by Internal Revenue Code Section 1031. If a taxpayer exchanges property with a related party, and either party disposes of their exchanged property within two years, the deferred gain may become immediately taxable. While exchanges with related parties are permitted, they carry an additional two-year holding period requirement to ensure deferral remains valid.