The 1031 exchange rules let you defer capital gains tax when you sell an investment or business real property by reinvesting the proceeds into another real property of like kind, using a qualified intermediary, and meeting two strict deadlines: 45 days to identify the replacement and 180 days to close.1Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment The tax is not forgiven. It is deferred, carried forward through the basis of the new property, and comes due whenever you finally sell without reinvesting.
What Property Qualifies
Both the property you give up and the property you receive must be real property held for investment or productive use in a trade or business.2Internal Revenue Service. Like-Kind Exchanges – Real Estate Tax Tips “Like-kind” is broader than most people expect. It describes the character of the property, not its use or grade. A raw parcel of land can be exchanged for a warehouse. A single-family rental can be exchanged for an apartment building or a retail strip. What matters is that both sides of the trade are investment or business real estate.
Since the Tax Cuts and Jobs Act of 2017, Section 1031 applies exclusively to real property. Equipment, vehicles, and other personal property no longer qualify.2Internal Revenue Service. Like-Kind Exchanges – Real Estate Tax Tips
What Does Not Qualify
A primary residence does not qualify because it is not held for business or investment. A second home or vacation property generally fails for the same reason. There is a narrow exception under Revenue Procedure 2008-16: the property must be rented at fair market rates for at least 14 days per year, and personal use cannot exceed the greater of 14 days or 10 percent of rental days, tested for each of the two years before the exchange on the property sold and each of the two years after on the replacement.3Internal Revenue Service. Like-Kind Exchanges Under IRC Section 1031
Property held primarily for sale is also excluded. Fix-and-flip projects and lots developed for resale are the standard examples. The IRS weighs your intent and holding pattern, so a short hold combined with little or no rental use tends to signal a dealer transaction rather than an investment one.1Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment
You Cannot Touch the Money
If you receive the sale proceeds at any point, even briefly, the IRS treats you as having taken the cash and the deferral is lost.4Internal Revenue Service. Sales Trades Exchanges The proceeds must instead go to a qualified intermediary, an independent third party who holds the funds and later uses them to acquire the replacement property for you.5Internal Revenue Service. Miscellaneous Qualified Intermediary Information
The exchange agreement with the intermediary has to be in place before the closing on the property you are selling. The closing agent then wires the proceeds directly to the intermediary, who holds them in a segregated account until you identify and close on the replacement. Administrative fees for a standard deferred exchange typically run $600 to $1,200.
Federal regulations also bar anyone who has served as your agent within the two years before the exchange from acting as your intermediary. That includes your attorney, accountant, real estate broker, investment banker, and their firms, and even the spouse of a disqualified agent. You need a professional intermediary with no prior advisory role in your affairs.
The 45-Day and 180-Day Deadlines
Two deadlines govern every deferred exchange, and the IRS does not extend either one. Both run from the date you transfer the property you are selling.
- You have 45 calendar days to identify potential replacement properties in writing. The notice must describe each property clearly, by legal description, street address, or recognizable name, and reach the intermediary before midnight on day 45. Weekends and holidays count.1Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment
- You must close on the replacement property within 180 calendar days of the initial transfer, or by the due date of your tax return for that year, whichever comes first.1Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment
The tax return due date catches people off guard. Sell in October, and your April 15 return due date arrives before day 180. The fix is to file an extension. The statute calculates the deadline “with regard to extension,” so a six-month filing extension preserves the full 180 days.3Internal Revenue Service. Like-Kind Exchanges Under IRC Section 1031 Miss either deadline and the entire deferred gain becomes taxable immediately.
How You Identify Replacement Properties
Treasury regulations offer three identification methods:6GovInfo. Treasury Regulation 1.1031(k)-1
- The three-property rule. Identify up to three properties regardless of combined value. This is the option most investors use.
- The 200-percent rule. Identify any number of properties, so long as their total fair market value does not exceed 200 percent of the value of the property you sold.
- The 95-percent rule. If you exceed the limits above, you still qualify only if you actually close on properties worth at least 95 percent of the total value of everything identified. It is a narrow escape hatch.
Identify too many properties and fail the 95-percent threshold, and the IRS treats you as having identified nothing. The exchange fails entirely.
Boot: The Part You Pay Tax On
An exchange does not have to be all or nothing. Anything you pull out of the transaction instead of reinvesting is called boot and is taxable in the year of the exchange, up to the amount of your realized gain. Receiving boot does not disqualify the rest of the exchange. It just means part of the gain gets recognized now.
Cash boot is the simplest form. If you direct the intermediary to send you $50,000 from a $500,000 sale and reinvest $450,000, that $50,000 is taxable. The same thing happens if the replacement property is worth less than the property sold: the shortfall in value becomes recognized gain.
Mortgage boot is debt relief. If the old property carried a $300,000 mortgage and the replacement has a $200,000 mortgage, the $100,000 reduction in debt is boot.1Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment To avoid it, take on debt on the replacement equal to or greater than the debt you paid off, or bring cash to closing to make up the difference.
The netting rules cut only one way. Cash you contribute to the purchase offsets mortgage boot, but adding more debt on the replacement does not offset cash boot you took from the sale. Missing that distinction is a common way to end up with an unexpected tax bill.
Recognized gain from boot is taxed at long-term capital gains rates of 0, 15, or 20 percent depending on your income and filing status, and higher-income investors may owe an additional 3.8 percent net investment income tax.7Internal Revenue Service. Topic No. 409, Capital Gains and Losses
Basis Carries Forward
A 1031 exchange defers tax by embedding the old property’s basis into the new one. Under Section 1031(d), the basis of the replacement equals the basis of the property given up, decreased by cash received and increased by any gain recognized.1Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment
Say you bought a rental for $200,000, took $60,000 in depreciation, and have an adjusted basis of $140,000. You exchange it for a $400,000 property with no boot. Your basis in the new property is $140,000, not $400,000. The $260,000 gap stays with the property as deferred gain. Sell for cash later, and you owe tax on the full accumulated gain from every property in the chain.
Depreciation recapture rides along in the same way. When the chain ends with a taxable sale, the portion of gain attributable to straight-line depreciation is taxed as unrecaptured Section 1250 gain at a federal rate of up to 25 percent. Accelerated depreciation, common after cost segregation, can be recaptured as ordinary income at rates up to 37 percent. The remaining gain is taxed at capital gains rates.
Reporting on Form 8824
Every like-kind exchange has to be reported on IRS Form 8824, filed with your federal return for the year the exchange began.8Internal Revenue Service. About Form 8824, Like-Kind Exchanges The form asks for descriptions of both properties, transfer dates, the adjusted basis of the property given up, cash and other non-like-kind property received, liabilities assumed by each side, and the resulting recognized or deferred gain.9Internal Revenue Service. Instructions for Form 8824 If you completed several exchanges in the same year, you can file a summary Form 8824 with individual statements for each.
The IRS will not confirm receipt unless it selects the return for examination. Missing or inaccurate reporting can bring penalties or full disqualification of the deferral.
Recordkeeping matters more here than for most tax filings. The general assessment window is three years from filing.10Internal Revenue Service. Topic No. 305, Recordkeeping But because basis carries forward across every replacement property, you need to prove the original basis whenever you finally sell for cash, which could be decades later. Keep closing statements, intermediary records, depreciation schedules, and exchange agreements for every property in the chain until three years after the return reporting the final taxable sale. For an investor who plans to keep exchanging, that is effectively forever.
Related-Party Exchanges
You can exchange with a family member or a controlled entity, but the rules tighten. Under Section 1031(f), if either party disposes of the exchanged property within two years, the deferral is retroactively disqualified and the gain is taxable in the year of that disposition.1Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment Related parties include siblings, spouses, ancestors, lineal descendants, and entities meeting specified ownership thresholds.
Three exceptions apply: death of either party, involuntary conversion such as a natural disaster, or a disposition where the taxpayer can satisfy the IRS that neither the exchange nor the later sale was motivated by tax avoidance.1Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment Section 1031(f)(4) also gives the IRS authority to deny deferral for any transaction structured to work around these limits, including routing an exchange through an intermediary to disguise a related-party cash-out.11Internal Revenue Service. Revenue Ruling 2002-83
When the Sequence Flips: Reverse and Improvement Exchanges
A standard deferred exchange sells first and buys second. When the replacement property surfaces before you have sold the old one, a reverse exchange flips the order. Revenue Procedure 2000-37 sets out a safe harbor: an exchange accommodation titleholder takes title to the replacement (or, less often, the relinquished property) and parks it for up to 180 days while you sell the old property and the intermediary completes the exchange. The 45-day identification requirement still applies. Reverse exchanges cost more and involve more moving parts because the EAT has to hold title, finance the acquisition, and manage the property during the parking period.
An improvement exchange, sometimes called build-to-suit, addresses a different problem: exchange funds cannot be spent on property you already own. The EAT takes title to the replacement, oversees construction paid for with exchange funds, and transfers the improved property to you within the 180-day window. Improvements made while the EAT holds title count toward your reinvestment target. Anything built after you take title does not.
The Long Game: Stepped-Up Basis at Death
The reason serious investors chain exchanges for decades sits in Section 1014. When a property owner dies, heirs take the property at a basis equal to its fair market value on the date of death.12Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent Every dollar of deferred capital gain and deferred depreciation recapture built up across a lifetime of exchanges disappears at that moment. Heirs can sell immediately at the stepped-up basis and owe nothing, or start their own chain.
Investors sometimes call this strategy “swap till you drop.” It is the reason many are willing to bear the cost and complexity of repeated exchanges rather than sell and pay the tax along the way.
State Tax Rules May Differ
Most states follow the federal 1031 rules, but not all do so fully. Some require separate reporting when properties cross state lines, and a few have clawback provisions that tax deferred gains when replacement property in another state is later sold. State depreciation recapture treatment can also diverge from federal. If your exchange involves more than one state, confirm that each state recognizes the deferral before assuming federal treatment carries through.