What Is a 1031 Exchange in Real Estate and How Does It Work?

A 1031 exchange in real estate is a transaction under Section 1031 of the Internal Revenue Code that lets an investor sell one investment property and buy another without paying capital gains tax at the time of the sale. The tax is deferred, not erased: the gain attaches to the replacement property and stays there until you sell in a taxable transaction. To qualify, the sale and purchase have to fit a specific definition of like-kind property, run through a third-party intermediary, and hit two strict deadlines.¹

What Property Qualifies

Section 1031 covers real property held for use in a trade, business, or for investment, exchanged for other real property also held for business or investment.¹ The like-kind standard is broad. An apartment building can be exchanged for a retail center, raw land for a warehouse, a rental house for a share in a commercial property. Use, not asset type, is what matters.

Several things are outside the rule. Your primary residence does not qualify because you live in it. Property held mainly for resale, such as houses a developer builds to flip, is excluded. Stocks, bonds, and partnership interests do not qualify. Since the Tax Cuts and Jobs Act of 2017, personal property like equipment and artwork no longer qualifies either; the section is now limited to real property. U.S. real estate and foreign real estate are not like-kind to each other, though you can exchange one foreign property for another.¹

Vacation homes sit in between. Revenue Procedure 2008-16 sets out a safe harbor: you have to rent the property at fair market rates for at least 14 days during each of the two 12-month periods before the sale (or after the purchase), keep your personal use during each of those periods to the greater of 14 days or 10 percent of the rental days, and own the property for at least 24 months on the relevant side of the exchange.²

The Two Deadlines That Control the Exchange

Both clocks start the day you transfer the property you are selling.

45 Days to Identify

You have 45 calendar days to identify potential replacement properties in writing, signed, and delivered to someone involved in the exchange, typically the qualified intermediary.³ If you actually close on the replacement inside that window, the identification requirement is satisfied automatically.⁴ Weekends and holidays do not extend the deadline.

180 Days to Close

You must close on the replacement property by the earlier of 180 days after the transfer of the relinquished property or the due date, including extensions, of your federal tax return for the year of the sale.⁴ That second rule catches investors off guard. Sell in October and your return is due the following April 15, which gives roughly 165 days rather than 180. Filing an extension pushes the return due date out and preserves the full 180-day window.

How Many Properties You Can List

Federal regulations give you three ways to identify replacements:

The three-property rule lets you name up to three properties regardless of combined value.
The 200-percent rule lets you name any number of properties as long as their total fair market value does not exceed 200 percent of what you sold.
The 95-percent rule is a fallback: if you blow through both limits above, you can still qualify only by actually acquiring replacements worth at least 95 percent of everything you identified.

If you exceed the three-property limit and the 200-percent cap without meeting the 95-percent threshold, the IRS treats you as having identified nothing at all, and the exchange fails.⁵

Why You Need a Qualified Intermediary

A qualified intermediary is a third party who holds the sale proceeds so you never take possession of them. If the money touches your hands, or an account you control, at any point in the process, the IRS treats the whole transaction as a taxable sale.³

Not everyone can play that role. The IRS disqualifies your attorney, accountant, real estate agent, or employee, along with anyone who has served in one of those capacities for you in the previous two years.³ The intermediary is engaged before the first closing, receives the buyer’s funds directly, holds them in a separate account, and disburses them to the seller of the replacement property when the second closing happens.

One thing worth knowing: the intermediary industry is not federally regulated. There is no federal licensing, bonding, or insurance requirement, so the safety of your funds depends on the specific firm you pick. Ask whether funds sit in a segregated account rather than a pool, and whether the company carries a fidelity bond and errors-and-omissions coverage.

Boot: When You Still Owe Tax

A 1031 exchange only defers gain on the portion of the deal that stays inside the exchange. Anything you pull out is called boot, and it is taxable up to the amount of gain you realized on the sale.¹ Boot shows up in two common forms.

Cash boot is sale proceeds you keep rather than reinvest. Sell for $500,000 and buy for $450,000, and the $50,000 difference is taxable. Mortgage boot is a reduction in debt. If the loan on the replacement property is smaller than the loan you paid off on the property you sold, the difference is treated as boot. Going from a $300,000 mortgage to a $200,000 mortgage produces $100,000 of mortgage boot.

For a fully tax-deferred exchange, the replacement property has to be equal to or greater in value than the one you sold, and all of the net equity has to be reinvested.

What Happens to the Deferred Gain

The gain does not vanish when the exchange closes. It attaches to the new property through a carryover basis: your basis in the replacement equals its purchase price minus the deferred gain. Sell a property with $175,000 in deferred gain and buy a $500,000 replacement, and your basis in the new property is $325,000. When you eventually sell in a taxable transaction, you owe tax on the original deferred gain plus any new appreciation.

Depreciation Recapture

Depreciation you claimed on the old property lowered your basis, and on a taxable sale the IRS recaptures those deductions at a federal rate of up to 25 percent. A 1031 exchange defers the recapture along with the capital gain, but the accumulated depreciation carries into the replacement property’s basis and waits for the eventual taxable sale.

Net Investment Income Tax

Higher-income investors may also owe the 3.8 percent net investment income tax on gains from investment real estate.⁶ Because no gain is recognized in the year of the exchange, this surtax is deferred alongside the capital gain and any recapture.

The Step-Up at Death

If you hold the replacement property until you die, your heirs receive a stepped-up basis equal to fair market value on the date of death.⁷ The step-up wipes out the deferred capital gain and depreciation recapture, so the tax you deferred may never be paid at all. This is the mechanic behind the long-hold “swap till you drop” approach.

Reverse and Improvement Exchanges

The standard exchange is deferred: sell first, buy within the deadlines. Two variations exist for situations that do not fit that order.

A reverse exchange lets you acquire the replacement property before selling the old one. Because you cannot own both for exchange purposes, the replacement is parked with an exchange accommodation titleholder. Revenue Procedure 2000-37 provides a safe harbor if the titleholder holds for no more than 180 days and the relinquished property sells inside that window.³ Reverse exchanges cost more because of the extra entity and paperwork.

An improvement exchange uses exchange funds to build or renovate before you take title. The 45-day identification has to include a legal description and as much construction detail as practicable. The work must be substantially complete within the 180 days, and you must end up with substantially the same property you identified. Anything unfinished at closing reduces the exchange value and can generate taxable boot.

Reporting the Exchange to the IRS

You report the exchange on Form 8824, Like-Kind Exchanges, attached to your federal return for the year the exchange began.⁴ The form asks for descriptions and transfer dates for both properties, the adjusted basis of what you gave up, the fair market value of what you received, any cash or boot received, and the exchange expenses you paid.⁸ Filing errors on Form 8824 can cause the IRS to treat the whole transaction as a taxable sale, so keep the settlement statements, identification letter, exchange agreement, and replacement purchase contract organized from the start.

1
Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment
2
Internal Revenue Service. Revenue Procedure 2008-16 – Qualifying Use Standards for Dwelling Unit in a 1031 Exchange
3
Internal Revenue Service. Like-Kind Exchanges Under IRC Section 1031
4
Internal Revenue Service. Instructions for Form 8824 – Like-Kind Exchanges
5
eCFR. 26 CFR 1.1031(k)-1 – Treatment of Deferred Exchanges
6
Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
7
Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent
8
Internal Revenue Service. About Form 8824, Like-Kind Exchanges