1031 Exchange: Rules And Basics To Know

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Chris Jennings is a writer and editor with more than seven years of experience in the personal finance and mortgage space. He enjoys simplifying complex mortgage topics for first-time homebuyers and homeowners alike. His work has been featured in a n.

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Updated: Nov 29, 2023, 3:00am

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1031 Exchange: Rules And Basics To Know

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A 1031 exchange, named after Section 1031 of the U.S. Internal Revenue Code, is a strategic tool for deferring tax on capital gains. You can leverage it to sell an investment property and reinvest the proceeds in a new one, effectively postponing the tax liability.

What Is a 1031 Exchange?

A 1031 exchange, also known as a like-kind exchange, is a powerful tax-deferment strategy popular with experienced real estate investors. It allows you to defer capital gains taxes on an investment property when it’s sold—as long as the investor purchases another like-kind property with the proceeds of the first property sale.

The term “like-kind” refers to the nature or character of the property, not its grade or quality. Essentially, there’s a wide variety of property types that you could consider to be like-kind. As long as the net market value of each successive property rises (or combined net market value, in the case of multiple replacement properties), you can exchange into like-kind properties indefinitely.

Example of a 1031 Exchange

Consider an investor who owns an apartment building valued at $1 million. The investor has held this rental property for several years and has accumulated substantial appreciation, making the building worth more now than when they initially purchased it. Now, the investor wants to diversify their portfolio, and they’re eyeing a commercial retail space in Boston worth $1.5 million.

The investor decides to utilize the 1031 exchange. They sell the apartment building and use the proceeds to acquire the retail space in Boston. By using the 1031 exchange, they can defer paying capital gains tax on the sale of the apartment building.

Despite changing their investment from residential real estate to commercial property, this transaction qualifies as a like-kind exchange because it involves similar types of assets (real estate). The net market value increases from one property to the next. Hence, the 1031 exchange allows the investor to seamlessly shift their real estate investment while postponing tax liabilities.

How To Do a 1031 Exchange

Conducting a 1031 exchange may seem daunting due to the complex rules and procedures involved. However, with a clear understanding and a systematic approach, it can be a smooth process.

Follow these steps to do a 1031 exchange:

Identify the property you want to sell. This must be an investment property—not a primary residence—and it should ideally have appreciated in value since you purchased it to take full advantage of the tax deferment benefits of a 1031 exchange.
Engage a qualified intermediary. Before you sell your property, hire a qualified intermediary (QI). This is a mandatory step because the IRS doesn’t allow the seller (you) to touch the money between the sale and the purchase of the new property. The QI holds the funds during this period.
List your property for sale. Once it sells, the proceeds (minus any costs, including debt payoff) go to the QI. The proceeds should not go to you or your bank account; otherwise, you’ll lose the 1031 exchange opportunity.
Identify potential replacement properties. You have 45 days from the date of sale to identify up to three potential replacement properties—regardless of their total value—or as many properties as you want, as long as their combined value doesn’t exceed 200% of the sold property’s value. You must record this in writing and deliver it to the QI.
Purchase the replacement property. From the date of sale of your initial property, you have 180 days to complete the purchase of any property or properties identified in the previous step. The QI then transfers the funds from the initial sale to the seller of the replacement property.
File Form 8824 with your taxes. When you file your taxes for the year the exchange took place, include Form 8824 in your tax return, notifying the IRS of the exchange and informing them what property you sold and what property you purchased as part of the exchange.

The IRS rules for 1031 exchanges are strict, so follow them closely. If done correctly, a 1031 exchange can be a powerful tool for building wealth through real estate investment.

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