A 1031 exchange lets you sell an investment or business property and roll the proceeds into another like-kind property without paying federal capital gains tax at the time of sale. The tax isn’t forgiven; it’s deferred into the new property’s basis. Named for Internal Revenue Code Section 1031, the technique preserves the full 15% to 20% of the gain that would otherwise go to federal capital gains tax, leaving that money invested. It only works if you follow the timeline, use the right intermediary, and stay inside the rules the IRS has drawn tightly around the transaction.
What Property Qualifies
Only real property held for investment or productive use in a trade or business qualifies. Since the 2017 Tax Cuts and Jobs Act, personal property — equipment, vehicles, artwork, intellectual property — is excluded from Section 1031 entirely.1Internal Revenue Service. Like-Kind Exchanges – Real Estate Tax Tips Property held mainly for resale is also out. If you flip houses as a business, those homes are inventory, taxed as ordinary income, and not exchange-eligible.
The “like-kind” standard is looser than it sounds. An apartment building can be exchanged for a strip mall, a warehouse, or raw land. What matters is that both properties serve an investment or business purpose, not that they resemble each other or produce income the same way.2Internal Revenue Service. Like-Kind Exchanges Under IRC Section 1031 – FS-2008-18 That breadth is why investors use 1031s to reposition across property types as markets shift.
Vacation Homes and Mixed-Use Property
A property you sometimes use personally can still qualify, but only under the thresholds the IRS set in Revenue Procedure 2008-16. For each of the two 12-month periods before the exchange (for the property you’re giving up) and after (for the replacement), both properties must meet the same test:
- Rented at fair market rates for at least 14 days.
- Personal use no more than the greater of 14 days or 10% of the days it was rented at fair market rates.
You also have to own each property for at least 24 months on the relevant side.3Internal Revenue Service. Revenue Procedure 2008-16 A beach condo you rent most of the year and visit for two weeks works. A lake house you use every weekend and rent occasionally does not.
The Two Deadlines That Control Everything
Once your original property closes, two clocks start on the same day.
You have 45 calendar days to identify potential replacement properties in writing to your intermediary.4Legal Information Institute. Tax-Deferred Exchange The identification must be signed and delivered before midnight on day 45. Weekends, holidays, and near-misses do not extend it. Miss this deadline and the exchange fails.
You then have 180 calendar days from the sale to close on the replacement — or until the due date of your tax return for the year of the sale, whichever comes first. That second cutoff catches people. If you sell in October and your return is due April 15, you actually have fewer than 180 days unless you file an extension. Filing a six-month extension is standard practice for late-year exchanges.
The Three Identification Rules
You only need to satisfy one of these three rules when you send in your written identification:
- Three-property rule: identify up to three replacement properties of any value. Most investors use this one.
- 200% rule: identify more than three properties as long as their combined fair market value doesn’t exceed 200% of the property you sold.
- 95% rule: identify any number of properties at any value, but you must actually acquire at least 95% of the total value you identified. Rarely practical.
If you identify four properties whose combined value exceeds 200% of what you sold, you have failed both the three-property and 200% rules. Unless you close on 95%, the IRS treats you as having identified nothing and the exchange fails.
The Qualified Intermediary
You cannot touch the money. A Qualified Intermediary (QI) must hold the sale proceeds in a segregated account and wire them directly to the closing agent for the replacement property. If the funds pass through your hands or an account you control at any point, the exchange fails and the full gain becomes taxable.5Internal Revenue Service. Miscellaneous Qualified Intermediary Information The QI has to be in place before the original property closes.
Not just anyone can serve. Anyone who has been your employee, attorney, accountant, real estate agent, or broker in the past two years is disqualified.6Internal Revenue Service. Revenue Procedure 2000-37 Your closing attorney or CPA cannot double as your QI. Fees for a standard delayed exchange usually run between $600 and $1,200. Reverse and improvement exchanges cost significantly more.
Same Taxpayer, Same Name
The name on title of the replacement property must match the name on the relinquished property. If you sold as “Jane Smith” but try to buy the replacement through “Smith Family LLC,” the exchange can be disqualified. Investors who hold different assets through different entities need to check title alignment before closing.
You report the exchange on IRS Form 8824 with your return for the year the exchange begins. The form tracks the properties, the transfer dates, and any recognized gain.7Internal Revenue Service. Instructions for Form 8824 Keep every closing statement, identification letter, and QI agreement.
Boot: When Part of the Gain Still Gets Taxed
Anything you receive in the exchange that isn’t like-kind real property is called boot, and it’s taxable. It shows up two ways.
Cash boot happens when the replacement property costs less than what you sold, and the leftover proceeds come back to you. Mortgage boot happens when the debt on the replacement is lower than the debt on the property you gave up; the debt relief is treated as an economic benefit.
Small amounts still count. Sell for $500,000 and reinvest $495,000, and that $5,000 is recognized gain at your capital gains rate. For full deferral, the replacement must be equal or greater in both value and debt, and every dollar of net proceeds has to be reinvested.4Legal Information Institute. Tax-Deferred Exchange You can offset mortgage boot by adding cash, but plan that before closing.
Depreciation Recapture Still Comes Along
If you claimed depreciation on the relinquished property, that portion of the gain faces a maximum federal rate of 25% when eventually recognized. A fully deferred exchange postpones the recapture with the rest of the gain, but doesn’t erase it. The deferred recapture carries into the replacement property’s basis and comes due if you ever sell without doing another exchange.
Related-Party Transactions
Exchanging property with a family member or an entity you control carries extra rules. If either party disposes of the property within two years, the deferral is disallowed and the original gain becomes taxable. Related parties include parents, children, siblings, and entities where you hold a significant ownership interest.
Even beyond that two-year rule, the IRS and courts have treated the use of a QI in related-party acquisitions as an attempt to sidestep the restriction, and have disqualified exchanges under an anti-avoidance theory. If a related party sits on either side, get specialized tax advice before you sign anything.
Reverse and Improvement Exchanges
Sometimes the replacement property becomes available before you have sold the old one. A reverse exchange addresses this with an Exchange Accommodation Titleholder (EAT) that takes title to the new property while you line up the sale of the original. Revenue Procedure 2000-37 provides a safe harbor when several conditions are met:6Internal Revenue Service. Revenue Procedure 2000-37
- A written agreement between you and the EAT executed within five business days of the EAT taking title.
- Written identification of the property you’ll relinquish within 45 days.
- The entire arrangement completed within 180 days.
- An EAT that is not your agent or otherwise disqualified.
Reverse exchanges cost more, commonly $3,000 to $8,500, because the EAT must hold title and sometimes arrange financing.
An improvement or build-to-suit exchange lets you use sale proceeds to construct or renovate the replacement. An EAT takes title while the funds pay for construction. All work has to be finished inside the 180-day window. Any unspent funds or unfinished improvements at the deadline become taxable boot, and the completed property must equal or exceed the value of what you sold for full deferral.
If the Exchange Falls Through
Miss the 45-day identification or the 180-day closing deadline and the exchange fails. The full gain from the original sale is taxable. The proceeds may still qualify for installment sale treatment if you made a genuine attempt to complete the exchange, letting you recognize the gain in the year you actually receive the cash from the QI rather than the year of sale. That can push the tax bill one year forward.
Installment reporting isn’t available if the IRS concludes you never seriously intended to close. Hold on to identification documents, inspection reports, correspondence with your QI, and anything that shows why the deal collapsed.
State Withholding Can Still Take a Cut
Section 1031 is federal. Many states impose their own withholding on real estate sales by nonresident sellers, commonly 2% to 8% of the sale price. Most states with withholding offer a 1031 exemption, but you generally have to file a specific state form before closing to claim it. Skip that paperwork and thousands can be withheld from your proceeds even though the federal exchange is valid. If you’re selling in a state where you don’t reside, confirm the exemption process with your QI or tax advisor well before closing.
Why Some Investors Never Cash Out
Under IRC Section 1014, heirs generally receive a stepped-up basis equal to the property’s fair market value at the date of death. All of the gain you deferred through successive exchanges is effectively wiped out at that point. Your heirs inherit at current value and owe no tax on the prior gains. That’s why some investors treat 1031 exchanges as a long-term estate planning tool, rolling gains forward with the expectation that the tax obligation dies with them.