What Is a 1031 Exchange? Know the Rules

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A 1031 exchange is a swap of one investment or business real estate property for another “like-kind” property that lets the owner defer, rather than pay, capital gains tax on the sale. It takes its name from Section 1031 of the Internal Revenue Code. If the exchange meets the rules, the gain on the old property carries over into the new one, and tax is due only when the replacement is eventually sold for cash. The rules are strict: both properties must be held for investment or business use, the sale proceeds cannot pass through your hands, and the replacement must be identified within 45 days and acquired within 180 days.

Understanding the 1031 exchange

Selling or trading property is normally a taxable event. Section 1031 is a nonrecognition rule: when its conditions are met, the gain is not recognized at the time of the exchange, so there is little or no tax due then. The gain still exists. It is postponed and attached to the replacement property through its tax basis.

Other names for the same transaction are a like-kind exchange, a tax-deferred exchange or a 1031 swap. Investors, agents, title companies and closing attorneys use “1031” as a verb (“we plan to 1031 the warehouse”). A purchase contract or closing questionnaire may ask whether you will use one, because the answer changes how funds and documents are handled.

There is no limit on how many times you can do a 1031 exchange, so an investor can roll gains from one property to the next for years. If the chain ends with a cash sale, tax is due then. Long-term capital gains are taxed at 0%, 15% or 20% depending on income, and depreciation recapture is handled separately. If the chain ends with the owner’s death, the deferred gain may never be taxed (see estate planning below).

What counts as like-kind property

The like-kind test looks at the nature of the property, not its grade or quality, and for real estate it is broad. An apartment building can be exchanged for raw land, a strip mall, an office building, a single-family rental or farmland. Both the relinquished property and the replacement property must be:

1. Real property located in the United States
2. Held for productive use in a trade or business or for investment
3. Not held primarily for sale

Property held primarily for sale, such as homes a developer or flipper builds or buys to resell, is treated like inventory and does not qualify. Interests in real estate held as a tenant in common (TIC) can qualify, because the owner holds a direct fractional interest in the real property.

What does not qualify

Before the Tax Cuts and Jobs Act (TCJA) of December 2017, certain exchanges of personal property qualified, including equipment, aircraft and franchise licenses. Since the TCJA, only real property as defined under Section 1031 qualifies.

Some assets never qualified and still don’t:

• Corporate stock, bonds and other securities
• Partnership interests (as distinct from direct TIC interests in real estate)
• Foreign real property exchanged for U.S. real property, or the reverse
• A personal residence used as your home, unless it has been converted to investment or business use

How a 1031 exchange works

The simplest version is a direct exchange: you deed your property to someone, and they deed theirs to you. A counterparty who owns exactly the property you want and wants exactly yours is rare. Most exchanges are therefore delayed, three-party exchanges, often called Starker exchanges after the court case that first allowed a gap between selling the old property and acquiring the new one. Here is the basic sequence:

1. Engage a qualified intermediary before closing. The intermediary, also called an exchange accommodator, facilitator or 1031 exchange company, is a third party that holds the sale proceeds and handles the exchange paperwork. You, your agent, your attorney or another person acting as your agent generally cannot fill this role.
2. Sell the relinquished property. The buyer’s funds go to the intermediary, not to you. If you take possession of the cash, or have the right to receive it, the exchange is spoiled and the sale becomes taxable.
3. Identify replacement property in writing within 45 days. The written identification goes to the intermediary or another permitted party.
4. Close on the replacement property within 180 days. The intermediary uses the held funds to buy the replacement, which is deeded to you.
5. Report the exchange on Form 8824 with your tax return for that year.

1031 exchange timeline: the 45-day and 180-day rules

Both deadlines start on the day the relinquished property is transferred, and they run concurrently, not one after the other. Missing either one usually means the exchange fails and the gain is taxable in the year of sale.

45-day identification rule

Within 45 days after transferring the relinquished property, you must identify potential replacement properties in writing and deliver the identification to a permitted party such as the qualified intermediary. Describe each property clearly, for example by legal description or street address.

The regulations limit how many properties you can name:

• Three-property rule: you may identify up to three properties of any value.
• 200% rule: you may identify more than three properties as long as their combined fair market value does not exceed 200% of the value of the relinquished property.
• 95% rule: if you exceed both limits, the identification is still valid only if you actually acquire properties worth at least 95% of the total value of everything you identified.

You do not have to buy every property you identify. You must, however, acquire replacement property from your identified list.

180-day closing rule

You must receive the replacement property within 180 days after transferring the relinquished property, or by the due date of your tax return for the year of the sale (including extensions), whichever comes first.

That second condition catches sellers who close late in the year. If you sell in late December and your return is due in mid-April, your exchange period ends on the return due date, well short of 180 days, unless you file an extension so the full 180 days remain available.

Reverse exchange

Sometimes the replacement property must be bought before the old one sells. A reverse exchange handles that sequence under a safe-harbor arrangement known as a qualified exchange accommodation arrangement (QEAA). An exchange accommodation titleholder (EAT) takes title to, or “parks,” a property during the exchange.

The same time windows apply. The relinquished property must be identified within 45 days after the EAT receives qualified indicia of ownership of the parked property, and the transaction must be completed, with the parked property transferred as the safe-harbor rules require, no later than 180 days after that transfer. Reverse exchanges require more paperwork and usually more financing, since you are carrying two properties for a time.

Tax implications: cash and debt (boot)

A 1031 exchange defers tax only on the value that stays in the exchange. Anything else you receive is “boot,” and boot generally triggers recognized gain up to the amount of boot received, never more than the total gain realized. The character of that gain (capital gain or depreciation recapture) follows the underlying gain.

Boot comes in two forms.

Cash boot. If you sell for $1 million and buy a replacement for $900,000, the $100,000 left over and returned to you is taxable. The same applies to proceeds used for non-exchange expenses at closing, such as paying off unrelated debts.

Mortgage (debt) boot. Debt relief counts like cash. If the mortgage on the property you give up is larger than the debt on the property you acquire, the reduction in liability is treated as boot even if you never receive a dollar. For example, selling a property with a $1 million mortgage and buying one with a $900,000 mortgage creates a $100,000 net reduction in debt. That $100,000 can be taxed, generally up to the lesser of your realized gain or the net boot received.

Failing to account for loans is one of the most common ways exchanges go wrong. You can offset debt relief by taking on equal or greater debt on the replacement property or by adding your own cash to the purchase. To defer all the gain, many investors buy a replacement of equal or greater value and reinvest all of the net proceeds, replacing any debt paid off with new debt or fresh cash.

Special rules for depreciable property

Rental and business buildings are depreciated over time, and those deductions reduce the property’s adjusted basis. When the property is sold, the IRS recaptures part of that benefit. For real property, the depreciation portion of the gain (unrecaptured Section 1250 gain) is taxed at a maximum rate of 25%, and in some cases additional depreciation can be taxed as ordinary income.

A qualifying exchange of one building for another generally defers the recapture along with the capital gain. The basis of the old property rolls into the new one, and in many exchanges the carried-over basis continues on the old property’s depreciation schedule, with any additional investment depreciated as new property.

The deferral is not automatic in every combination. If you exchange improved land with a building for unimproved land with no building, some depreciation may be recaptured as ordinary income, depending on the Section 1250 limits and the replacement property acquired.

Vacation homes and second homes

Taxpayers once swapped one vacation home for another, moved into the replacement and later sold it using the home-sale exclusion. That exclusion lets married couples filing jointly exclude up to $500,000 of gain ($250,000 for most single filers) if they meet the ownership and use tests, generally including living in the home for at least two of the five years before the sale.

Congress tightened that route in 2004, but a vacation home can still enter a 1031 exchange if it is genuinely converted to investment use. For example, you stop using a beach house yourself, rent it out at fair rental value for a period, and then exchange it. A property that is merely offered for rent but never actually rented does not meet the IRS safe harbor.

The Rev. Proc. 2008-16 safe harbor

In 2008 the IRS issued Revenue Procedure 2008-16, which says the IRS will not challenge whether a dwelling unit qualifies as investment property for Section 1031 if certain tests are met. For a relinquished dwelling, the tests apply to each of the two 12-month periods immediately before the exchange. For a replacement dwelling, they apply to each of the two 12-month periods immediately after it. In each period:

• The dwelling must be rented to another person at a fair rental for 14 days or more.
• Your personal use must not exceed the greater of 14 days or 10% of the days it is rented at a fair rental.

Falling outside the safe harbor does not automatically disqualify an exchange, but it removes the IRS’s assurance and leaves the question to the facts and circumstances.

Moving into a replacement property

If you plan to live in the replacement property eventually, you cannot move in right away. Doing so undercuts the claim that it was acquired for investment, and the safe harbor requires two years of qualifying rental use after the exchange.

The 2004 change adds a second limit. If you acquire a property in a 1031 exchange and later sell it as your principal residence, the home-sale exclusion does not apply unless the sale occurs at least five years after the date you acquired the property in the exchange. Even then, the exclusion does not cover all the gain: gain attributable to periods when the home was not used as your principal residence, and depreciation taken after May 6, 1997, remain taxable.

1031 exchanges in estate planning

The deferral has its largest effect when the owner holds the final replacement property until death. Under Section 1014, heirs generally receive inherited property with a basis stepped up to its fair market value at the date of death. The gain deferred through one or more exchanges during the owner’s lifetime, including deferred depreciation recapture, can be eliminated rather than merely postponed.

That is why investors who expect to hold real estate long term often chain exchanges rather than sell. The trade-off is that the wealth stays concentrated in property, which can be harder to divide among heirs than cash or securities.

How to report a 1031 exchange to the IRS

You report the exchange on Form 8824, Like-Kind Exchanges, filed with your tax return for the year the exchange occurs. The form asks for:

• Descriptions of the properties given up and received
• The dates the replacement property was identified and the dates each property was transferred
• Any relationship with the other party to the exchange
• The fair market values of the like-kind properties
• The adjusted basis of the property given up
• Liabilities assumed and relinquished, and any cash or other boot

The form calculates the recognized gain (from boot), the deferred gain and the basis of the replacement property. An exchange that spans two tax years is reported for the year the relinquished property was transferred. Errors or rule violations can lead the IRS to disallow the deferral, leaving you with the full tax bill plus interest and possible penalties.

Exchanges with related parties, such as family members or entities you control, are allowed but carry an extra condition: if either party disposes of the exchanged property within two years, the deferral generally unwinds. Form 8824 includes a section for reporting related-party exchanges in the year of the exchange and the two following years.

Examples

The following are hypothetical examples; the figures are not taken from any real transaction.

Example 1: Full deferral into a larger property

An investor bought an apartment building for $1 million seven years ago and has claimed $300,000 of depreciation, leaving an adjusted basis of $700,000. The building now sells for $2 million (net of selling costs, for simplicity). The realized gain is $1.3 million.

Through a qualified intermediary, the investor uses the full $2 million of proceeds plus a new $500,000 loan to buy a $2.5 million building in an area with higher rents. No cash is received and debt increases, so there is no boot. The entire $1.3 million gain is deferred.

The replacement property’s basis is $1.2 million: the old basis of $700,000 plus the $500,000 of additional investment. Equivalently, it is the $2.5 million price minus the $1.3 million deferred gain.

Example 2: Cash boot

Same sale, but the investor buys a $1.8 million replacement with no new debt and takes $200,000 back from the intermediary. That $200,000 is boot. Because it is less than the $1.3 million realized gain, $200,000 of gain is recognized and taxed in the year of the exchange (with the depreciation portion taxed under the recapture rules). The remaining $1.1 million is deferred.

Holding real estate in an LLC

Putting property in an LLC does not by itself avoid federal tax on a sale. A single-member LLC is generally a disregarded entity for federal income tax purposes, so the IRS treats its owner as the seller. Even in a state with no individual income tax, such as Wyoming, federal capital gains tax and depreciation recapture still apply.

What an LLC changes is who the taxpayer is for exchange purposes. The taxpayer that sells the relinquished property generally must be the same taxpayer that acquires the replacement. A single-member LLC owner can usually sell through the LLC and buy in their own name, or the reverse, because the IRS sees one taxpayer. A multi-member LLC taxed as a partnership is the taxpayer itself. Its members cannot simply exchange their individual shares, since partnership interests do not qualify. Structural changes around an exchange are where professional tax advice matters most.

FAQs

The Bottom Line

A 1031 exchange suits real estate investors who plan to stay in property and want to keep gains working instead of paying tax at each sale. To defer the full gain, use a qualified intermediary, meet both deadlines, and buy a replacement of equal or greater value while replacing any debt paid off. Vacation homes, related-party deals and LLC ownership carry extra conditions that call for careful planning.