What Is a 1031 Tax-Deferred Exchange and How It Works

A 1031 tax-deferred exchange lets you sell investment or business real estate, reinvest the proceeds in replacement property, and postpone the capital gains tax you would otherwise owe on the sale. Named after Section 1031 of the Internal Revenue Code, it doesn’t erase the tax. It rolls the gain forward by carrying your old tax basis into the new property. Keep exchanging, and you can defer that liability across decades and multiple properties.

How the Deferral Works

The mechanism is a basis carryover, not a tax holiday. When you exchange qualifying property, the IRS treats the transaction as a continuation of your original investment. Your basis in the replacement property equals your adjusted basis in the old one, rather than resetting to the new purchase price.¹

A concrete example. You bought a rental for $200,000, claimed $50,000 in depreciation, and now sell it for $400,000. Your adjusted basis is $150,000, so your realized gain is $250,000. In a full 1031 exchange, you pay nothing on that gain now. Your replacement property’s basis starts at $150,000, not at its purchase price. If you later sell the replacement outright, the entire accumulated gain becomes taxable.

What Property Qualifies

Since the Tax Cuts and Jobs Act took effect in 2018, only real property qualifies. Equipment, vehicles, artwork, and intangibles are out.² Both the property you sell and the property you buy must be held for use in a business or for investment.

Property held primarily for resale doesn’t qualify. A developer flipping houses is holding inventory, and inventory is excluded.¹ Your personal residence doesn’t qualify either. The IRS looks at intent and actual use, so mixed-use properties can create gray areas worth reviewing with a tax professional before you commit.

“Like kind” refers to the nature of the property, not its specific use. An apartment building is like-kind to raw land. A strip mall is like-kind to a single-family rental. Most U.S. real estate is like-kind to other U.S. real estate, which gives you wide latitude in choosing a replacement.³

A few boundaries. Foreign real estate is not like-kind to U.S. real estate. Leasehold interests count as like-kind only if the remaining term is 30 years or more.⁴ Partnership interests are excluded from 1031 treatment. Vacation homes can qualify, but only if you meet a specific safe harbor covering rental days, personal use, and holding period under Revenue Procedure 2008-16.⁵

The Two Deadlines That Control Everything

Two hard deadlines govern every exchange, and both start the day you close on the sale of your old property. Miss either one by a day and the exchange collapses into a fully taxable sale. Weekends and holidays do not extend them.

The 45-Day Identification Period

Within 45 calendar days of closing, you must deliver a written, signed list of potential replacement properties to your intermediary or another party to the exchange.³ The list has to describe each property specifically enough for someone to identify it unambiguously, usually a street address or legal description.

Two identification rules cover almost every situation. The three-property rule lets you name up to three replacements regardless of value. The 200-percent rule lets you name more than three, as long as their combined fair market value doesn’t exceed twice the value of what you sold.⁶ Most investors use the three-property rule for its simplicity and its room for backups if a deal falls through.

The 180-Day Exchange Period

You must close on one or more identified properties within 180 calendar days of the original sale, or by the due date of your tax return for the year of the sale, whichever comes first.³ That tax-return cutoff catches people off guard. If you sell in October, your 180 days may run into April, but your return is also due in April. The fix is routine: file for an extension, which pushes the return deadline out and preserves the full 180 days. Your intermediary will likely remind you.

The Qualified Intermediary

You cannot handle the sale proceeds yourself. A qualified intermediary, sometimes called an accommodator, holds the funds after closing and uses them to purchase the replacement property on your behalf. If you take receipt of the money at any point, even briefly, the exchange fails and the full gain becomes taxable.

The intermediary has to be independent. Anyone who has been your employee, attorney, accountant, investment banker, or real estate agent within the two years before the exchange is disqualified.⁷ The rule prevents the IRS from treating the arrangement as a disguised payment to you.

Fees for a standard delayed exchange typically run $800 to $1,500. Reverse and construction exchanges cost more. Before hiring one, ask how the funds are held. Reputable intermediaries use separate, segregated accounts rather than pooling exchange money with their own operating funds. Federal regulation of intermediaries is minimal, and a bankruptcy involving commingled accounts can wipe out both your money and your exchange. A handful of states have their own oversight rules.

How the Transaction Is Structured

The choreography exists to keep the sale proceeds out of your hands from start to finish:

Before the old property closes, you assign your rights under the sales contract to your qualified intermediary, and the buyer receives notice of the assignment.
At closing, the proceeds wire directly to the intermediary’s restricted account, not to you.
Within 45 days, you deliver your signed identification list.
When you go under contract on a replacement property, you assign the purchase rights to the intermediary, which uses the held funds to buy it and transfer title to you.

Before you start, gather the documentation you’ll need for the gain calculation: original purchase price, capital improvements, total depreciation claimed, the deed’s legal description, and any outstanding mortgage details.

Boot and Partial Exchanges

An exchange doesn’t have to be all-or-nothing. Any cash or non-like-kind property you receive is “boot,” and it’s taxable up to the amount of your realized gain.¹ Receiving boot doesn’t kill the exchange; it just makes part of it taxable.

Boot commonly appears in three ways. Cash pulled at closing before the intermediary receives the proceeds is boot. Buying replacement property worth less than what you sold creates boot equal to the difference. Reducing your debt (a $300,000 mortgage on the old property replaced by a $200,000 mortgage on the new one) counts as boot unless you offset it with cash.

The cleanest way to avoid boot is to buy replacement property worth at least what you sold, reinvest all the proceeds, and take on equal or greater debt. Some investors who can’t find a single large enough replacement acquire fractional interests in additional properties, such as shares in a Delaware Statutory Trust, to absorb remaining proceeds.

Reverse and Construction Exchanges

A standard delayed exchange assumes you sell before you buy. Two variations handle other timing.

In a reverse exchange, you acquire the replacement first. Because you can’t own both properties simultaneously during the exchange, an Exchange Accommodation Titleholder takes title to one of the properties and “parks” it. Revenue Procedure 2000-37 provides a safe harbor requiring a written agreement within five business days of the transfer, identification within 45 days, and completion within 180 days.⁸ Reverse exchanges cost several thousand dollars more than standard ones.

A construction or “build-to-suit” exchange uses the same parking structure to make improvements on the replacement property using exchange funds. All construction must be finished and title conveyed within the 180-day window. Improvements completed after day 180 don’t count toward the exchange value, which can leave you with taxable boot if the timely improvements don’t close the value gap.

Related-Party Restrictions

Exchanges with related parties face extra scrutiny. If you do a 1031 exchange with a related party and either of you sells the exchanged property within two years, the deferred gain snaps back into taxable income for the year of that early sale.¹ Related parties include siblings, parents, children, grandchildren, and entities you own more than 50 percent of.⁹ Exceptions apply for death, involuntary conversions like eminent domain, and situations where tax avoidance wasn’t a principal purpose.

Depreciation Recapture and the Estate Step-Up

Deferring capital gains is only part of what a 1031 exchange does. When you sell investment real estate outside an exchange, the portion of your gain attributable to prior depreciation (unrecaptured Section 1250 gain) is taxed at up to 25 percent, higher than the 0, 15, or 20 percent long-term capital gains rates.¹⁰ Higher-income investors also owe a 3.8 percent net investment income tax on real estate gains.¹¹

Related-party exchanges have extended reporting: you file Form 8824 for the two tax years following the exchange to confirm neither party has disposed of the property prematurely.¹² Keep closing statements, assignment agreements, identification letters, and intermediary correspondence for as long as you hold the replacement property, plus three years after you file the return reporting the eventual sale.

1
Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment
2
Internal Revenue Service. Like-Kind Exchanges – Real Estate Tax Tips
3
Internal Revenue Service. Like-Kind Exchanges Under IRC Section 1031
4
eCFR. 26 CFR 1.1031(a)-1 – Property Held for Productive Use in Trade or Business or for Investment
5
Internal Revenue Service. Revenue Procedure 2008-16
6
Government Publishing Office. 26 CFR 1.1031(k)-1 – Treatment of Deferred Exchanges
7
Internal Revenue Service. 26 CFR Part 1 – Definition of Disqualified Person
8
Internal Revenue Service. Revenue Procedure 2000-37
9
Internal Revenue Service. Revenue Ruling 2002-83
10
Internal Revenue Service. Topic No. 409 – Capital Gains and Losses
11
Internal Revenue Service. Instructions for Form 8824