What Is a 1035 Exchange in Real Estate vs. 1031?

A 1035 exchange in real estate isn’t a real thing. Section 1035 of the Internal Revenue Code covers tax-free swaps of life insurance, annuity, endowment, and long-term care contracts — not property. If you’re trying to defer capital gains tax on the sale of investment or business real estate, the provision you want is Section 1031, which allows “like-kind” exchanges of real property. The numbering is close, the concept of a tax-deferred swap is similar, and that’s where the confusion begins.

What Section 1035 Actually Covers

Section 1035 lets a policyholder swap one insurance-type contract for another without recognizing gain on the built-up value. The permitted exchanges run in one direction: life insurance can go to another life insurance policy, an endowment, an annuity, or a qualified long-term care contract; an annuity can go to another annuity or a long-term care contract; but you cannot move an annuity back into life insurance. Both contracts must cover the same insured person.¹

None of this reaches real estate. If a broker, advisor, or article tells you to do a “1035 exchange” on a rental building, land, or a commercial property, they mean Section 1031 and have the number wrong.

Section 1031: The Real Estate Provision You Actually Want

Section 1031 allows you to sell investment or business real estate and reinvest the proceeds into replacement real estate without paying capital gains tax at the time of the sale. The IRS treats the transaction as a continuation of your original investment rather than a taxable disposition.²

The “like-kind” label sounds restrictive but almost isn’t. Nearly any real estate is like-kind to any other real estate as long as both properties are held for productive use in a trade or business or for investment. You can exchange raw land for an office building, a warehouse for an apartment complex, or a strip mall for a single-family rental. What matters is the purpose you hold the property for, not what the property looks like or how it’s used.

The tax is deferred, not forgiven. Your gain follows you into the replacement property through a carryover basis and remains there until you eventually sell in a fully taxable transaction. For long-term investors, though, that “eventually” can turn into “never” — more on that below.

Which Properties Qualify

Both the property you sell (the relinquished property) and the property you buy (the replacement property) must be held for business use or investment. That single requirement rules out several common situations:

Your primary residence doesn’t qualify, because you live in it rather than hold it for investment. A separate provision, Section 121, may cover the sale of a personal home.
Fix-and-flip properties are treated as inventory rather than investment property, and inventory is excluded. The IRS looks at your intent at the time of purchase.
Partnership interests generally cannot be exchanged, with a narrow exception for partnerships that have elected out of partnership tax treatment under Section 761(a).²
U.S. property exchanged for foreign property (or the reverse) does not qualify. Both properties must sit in the same country.

Vacation homes occupy a middle ground. The IRS published a safe harbor that clears them for 1031 treatment if you rent the property at fair market rates for at least 14 days during each of the two 12-month periods before or after the exchange, and your personal use in each of those periods stays within the greater of 14 days or 10 percent of the days it was rented.³

The 45-Day and 180-Day Deadlines

Two statutory deadlines control every deferred 1031 exchange, and both start on the day you transfer the relinquished property to the buyer.

Within 45 days, you must formally identify potential replacement properties in writing, delivered to your qualified intermediary or another non-disqualified party to the exchange. A street address or legal description works; a vague description like “a property in Phoenix” does not.⁴

Within 180 days, you must close on the replacement property, or by the due date of your tax return (including extensions) for the year of the sale, whichever comes first.² The 180 days runs concurrently with the 45-day window, not after it. Both are fixed by statute. The IRS cannot extend them for hardship, a deal falling through, or anything short of a presidentially declared disaster.⁵

Watch the tax-return trap. Sell a property on December 1 and file your return on April 15 without an extension, and your 180-day window collapses to roughly 135 days. Filing an extension restores the full 180. Most exchange advisors recommend filing an extension by default.

Three Ways to Identify Replacement Properties

Within the 45-day window, you satisfy the identification requirement by using one of three methods:

The three-property rule lets you identify up to three properties of any value. It’s the most commonly used method and gives you backup options if a deal falls apart.
The 200-percent rule lets you identify any number of properties, so long as their combined fair market value doesn’t exceed 200 percent of the value of the property you sold.
The 95-percent rule lets you identify any number of properties at any value, but you must actually acquire at least 95 percent of the total value of what you identified.

Blow past the limits of all three, and the IRS treats you as having identified nothing. The exchange collapses.⁶

You Need a Qualified Intermediary

You cannot touch the sale proceeds. If the money hits your bank account between the sale and the purchase, the IRS treats the transaction as a completed sale and the exchange fails. A qualified intermediary (QI), sometimes called an exchange facilitator, holds the funds in escrow after the sale and uses them to acquire the replacement property on your behalf.⁵

Not just anyone can serve as your QI. Anyone who has acted as your employee, attorney, accountant, real estate agent, or investment broker within the two years before the sale is disqualified. So is every attorney in your attorney’s firm and every agent in your agent’s brokerage. You need a dedicated exchange company, not your closing attorney.⁷

One risk most investors overlook: QI companies are largely unregulated at the federal level. Funds held by a QI are not protected by FDIC insurance. If the QI goes bankrupt or misappropriates the money, you bear the loss. Look for companies that use segregated accounts at FDIC-insured banks, carry fidelity bonds and errors-and-omissions insurance, and have a real track record. Fees for a standard forward exchange typically run $600 to $1,200; reverse and improvement exchanges cost significantly more.

Boot: When Part of the Exchange Gets Taxed

A perfectly structured 1031 exchange defers all capital gains tax. When the exchange isn’t perfect, the shortfall gets taxed immediately. That taxable portion is called boot, and it comes in two forms.

Cash boot is any leftover money the QI sends you after buying the replacement property, or any excess proceeds when the replacement costs less than the relinquished property. Cash boot is taxable in the year of the exchange.

Mortgage boot is subtler. If the debt on your replacement property is lower than the debt on the property you sold, the IRS treats the reduction as if you received cash. Sell a property with a $500,000 mortgage and buy a replacement with a $350,000 mortgage, and $150,000 is mortgage boot, taxable up to the amount of your realized gain. You can offset mortgage boot by putting your own cash into the deal to make up the difference.

To achieve full deferral, the replacement property must be of equal or greater value, and your combined new debt plus cash invested must equal or exceed what you had in the property you sold.

Basis, Depreciation Recapture, and the Step-Up at Death

Your basis in the relinquished property carries over to the replacement property. The new basis equals the old basis, plus any additional cash you invested or new debt you took on, minus any boot you received. This carryover is what preserves the deferred gain — and it also preserves your accumulated depreciation.

When you eventually sell a property in a fully taxable transaction, two taxes come due on the gain. The appreciation above your original purchase price is taxed at the long-term capital gains rate, which tops out at 20 percent. All the depreciation you claimed over the years — the “unrecaptured Section 1250 gain” — is taxed at a rate capped at 25 percent. High-income investors may also owe the 3.8 percent Net Investment Income Tax on top.⁸

The endgame is Section 1014. When a property owner dies, heirs receive the property with a basis stepped up to its fair market value on the date of death.⁹ All the deferred gain from every prior 1031 exchange, and all the accumulated depreciation recapture, disappears.

An investor who bought a rental for $200,000, ran it through decades of 1031 exchanges, and died holding a property worth $2 million leaves heirs with a $2 million basis. They can sell the next day with no federal tax on that appreciation. This combination of lifetime deferrals and a stepped-up basis at death is why many investors keep exchanging even when the transactional costs feel heavy.

Reverse Exchanges and Related-Party Rules

In a standard 1031 exchange, you sell first and buy second. A reverse exchange flips that order for situations where you find the ideal replacement before your current property has sold. The IRS safe harbor uses an Exchange Accommodation Titleholder, typically a special-purpose LLC, which takes legal title to whichever property is being parked.¹⁰ The same 45-day and 180-day deadlines apply, starting from the day the titleholder acquires the parked property. Expect combined QI and titleholder fees in the range of $3,000 to $8,500.

Exchanges between related parties are allowed but carry a mandatory two-year holding period on both sides. If either party sells the exchanged property within two years, the deferred gain becomes taxable in the year of that later sale.¹¹ The rule blocks basis-shifting schemes. Two narrow exceptions apply: death of a party during the holding period, or loss of the property through an involuntary conversion like condemnation.

Reporting the Exchange on Form 8824

Every 1031 exchange gets reported on Form 8824, filed with your tax return for the year you transferred the relinquished property. The form calculates the deferred gain, any recognized gain from boot, and the basis of the replacement property.⁴ Related-party exchanges require Form 8824 for each of the two tax years following the exchange as well, whether or not any further transactions occurred. Given how easily basis calculations and boot allocations go sideways, most investors have a tax professional prepare the form.

1
Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies
2
Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment
3
Internal Revenue Service. Revenue Procedure 2008-16 – Safe Harbor for Dwelling Units in Section 1031 Exchanges
4
Internal Revenue Service. Instructions for Form 8824 (2025)
5
Internal Revenue Service. Like-Kind Exchanges Under IRC Section 1031
6
eCFR. 26 CFR 1.1031(k)-1 – Treatment of Deferred Exchanges
7
Internal Revenue Service. Miscellaneous Qualified Intermediary Information
8
Internal Revenue Service. Net Investment Income Tax
9
Office of the Law Revision Counsel. 26 U.S. Code 1014 – Basis of Property Acquired From a Decedent
10
Internal Revenue Service. Revenue Procedure 2000-37 – Property Held for Productive Use in Trade or Business or for Investment
11
Office of the Law Revision Counsel. 26 U.S. Code 1031 – Exchange of Real Property Held for Productive Use or Investment