1031 Property Exchanges

What a 1031 exchange does

Section 1031 of the Internal Revenue Code lets you trade one piece of investment or business real estate for another without recognizing the gain on the sale. Instead of paying capital gains tax and depreciation recapture now, the untaxed gain rolls into the replacement property. You pay it later, when you sell without doing another exchange. If you hold the property until death, your heirs generally receive a stepped-up basis and the deferred gain is never taxed.

What property qualifies

Both the property you sell and the property you buy must be held for investment or for use in a trade or business. “Like-kind” is broad for real estate: a rental house can be exchanged for raw land, a commercial building, or a share of a larger property held through a Delaware statutory trust.

What doesn’t qualify:

• Your personal residence (see our article on combining the home-sale exclusion with a 1031 exchange)
• Property you hold mainly to resell, such as fix-and-flip houses
• A vacation home you use mostly yourself
• Personal property such as equipment and vehicles. Since 2018, only real estate qualifies.
• Property outside the United States exchanged for U.S. property, or the reverse

The deadlines

Two clocks start the day you close on the sale, and neither can be extended for ordinary reasons such as a slow lender:

• 45 days to identify replacement properties in writing to your intermediary. Most people use the three-property rule: you may name up to three properties of any value.
• 180 days to close on the replacement property. If your tax return is due before the 180 days run out, extend the return so the full period stays available.

The qualified intermediary

You can’t touch the sale money. If proceeds pass through your own account, even briefly, the exchange fails and the sale is taxable. A qualified intermediary holds the funds between the sale and the purchase. The intermediary has to be engaged before the sale closes. Your own attorney, real estate agent, or accountant who has worked for you in the past two years can’t serve in that role.

Boot: when part of the gain is taxed

To defer all of the gain, the replacement property should cost at least as much as the net sale price, and you should reinvest all of the cash. Anything you receive that isn’t like-kind property is called boot and is taxable up to the amount of your gain. Common sources of boot:

• Cash kept from the sale
• Paying off a larger mortgage than you take on, unless you add cash to make up the difference
• Sale proceeds used to pay non-closing costs

Basis and depreciation afterward

The replacement property takes over the old property’s adjusted basis, increased by any extra cash you invest. That means lower depreciation deductions than if you had bought the new property outright, and the deferred gain is still there when you eventually sell. The exchange is reported on Form 8824 with your return for the year of the sale.

Related-party exchanges and holding periods

Exchanges with family members or related entities are allowed but must be held by both sides for two years afterward. There is no fixed holding period in the law for unrelated exchanges, but property acquired and quickly resold looks like property held for sale, not investment. Many advisers suggest holding both properties at least a year or two.

Before you list the property

A 1031 exchange has to be planned before the sale closes. It often makes sense to run the numbers first: in some years, particularly when other income is low, simply paying the tax can cost less than you’d expect. Our article on what selling a rental really costs in tax explains how we calculate it.

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