What Is a 1031 Exchange?
IRC Section 1031 allows you to sell an investment property and defer all capital gains tax and depreciation recapture by reinvesting the proceeds into a replacement property of equal or greater value.
The tax is deferred, not eliminated. Your basis in the replacement property carries over from the relinquished property. But deferral can last indefinitely. Many investors exchange repeatedly throughout their careers and never pay the deferred tax. At death, heirs receive a stepped-up basis, effectively eliminating the deferred gain.
The result: you can sell a $500K property with $200K in gains, buy a $700K property, and pay zero tax today. The $200K in deferred gain reduces your basis in the new property, but you continue deferring through future exchanges.
Qualifying Property
Both the property you sell (relinquished) and the property you buy (replacement) must meet these requirements:
Like-Kind Requirement
"Like-kind" is broader than most people think. Any real property held for investment or business use is like-kind to any other real property held for investment or business use. You can exchange:
- A single-family rental for a 20-unit apartment building
- Raw land for a commercial office building
- A retail strip mall for a warehouse
- A rental condo for vacant land
What Does NOT Qualify
- Primary residences and second homes used personally
- Property held for resale (fix-and-flip inventory)
- Personal property (equipment, vehicles, artwork) after the TCJA eliminated personal property exchanges
- Foreign real property exchanged for domestic real property (or vice versa)
- Partnership interests (but interests in entities that own real estate may qualify with careful structuring)
Holding Period
There is no statutory minimum holding period, but the IRS looks at intent. Properties held less than one year raise dealer/inventory concerns. A safe harbor: hold the relinquished property for at least 24 months and the replacement property for at least 24 months before any personal use or subsequent sale.
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The 45/180-Day Rules
These deadlines are absolute. No extensions for weekends, holidays, or market conditions.
45-Day Identification Period
Starting from the day you close on the sale of your relinquished property, you have 45 calendar days to identify replacement properties in writing to your QI. Three identification rules:
- Three-Property Rule: Identify up to 3 properties regardless of their total value. Most commonly used.
- 200% Rule: Identify any number of properties as long as their total fair market value does not exceed 200% of the relinquished property's sale price.
- 95% Rule: Identify any number of any value, but you must acquire 95% of the total value identified. Rarely used due to the high acquisition threshold.
180-Day Exchange Period
You must close on the replacement property within 180 calendar days of selling the relinquished property. If your tax return is due before day 180, you must either close before the return deadline or file an extension.
Critical Planning Point
Always file a tax extension if your 180-day period extends past your filing deadline. Missing this is one of the most common 1031 exchange failures. If you sell in October, your 180 days run into April. Without an extension, your return due date comes first and the exchange fails.
Qualified Intermediary Requirements
You cannot handle exchange funds yourself. A qualified intermediary (QI) holds proceeds from the sale and disburses them to purchase the replacement property.
Who Cannot Serve as QI
The IRS disqualifies anyone who has served as your agent within the prior two years:
- Your attorney or law firm
- Your CPA or accounting firm
- Your real estate agent or broker
- Your employee or any related party
What to Look for in a QI
- Fidelity bond and errors/omissions insurance: Protects you if the QI mishandles funds or makes a mistake.
- Segregated accounts: Your funds should be held separately, not commingled with other clients' money.
- Experience and reputation: Ask how many exchanges they have handled. Check references.
- FDIC-insured accounts: Ensure funds are held in FDIC-insured accounts, ideally in your tax ID number.
Warning
QIs are not federally regulated. Several have gone bankrupt or committed fraud, taking client funds with them. Do your due diligence. Verify insurance, bonding, and segregated accounts before signing.
Understanding Boot
Boot is anything you receive in the exchange that is not like-kind real property. Boot is taxable.
Types of Boot
- Cash boot: If the replacement property costs less than the sale price, the leftover cash is boot. Example: sell for $500K, buy for $450K, and $50K is taxable cash boot.
- Mortgage boot: If the mortgage on your replacement property is less than the mortgage on the relinquished property, the reduction in debt is treated as boot. Sell a property with a $300K mortgage and buy one with a $200K mortgage, and $100K is mortgage boot.
- Non-like-kind property: Personal property received in the exchange (furniture included in the sale, for example) is boot.
How to Avoid Boot
- Reinvest 100% of sale proceeds into the replacement property.
- Replace or exceed the mortgage amount on the relinquished property.
- If you must reduce debt, offset mortgage boot by adding cash from outside the exchange.
- Ensure all proceeds flow through the QI. Do not take any distributions.
Taxstra Tip
Run the boot calculation before closing. Work backward from the replacement property price and financing to ensure you are not inadvertently creating boot. Your CPA and QI should both review the numbers before the exchange closes.
Planning a 1031 Exchange?
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