1031 Exchange Basics: How Real Estate Investors Defer Capital Gains Taxes
A like-kind exchange lets investors roll the gains from one property into another without paying tax now, but the 45-day and 180-day deadlines are strict.
In this article
When you sell an investment property at a profit, you normally owe capital gains tax plus depreciation recapture. A 1031 exchange, named after Section 1031 of the Internal Revenue Code, lets you defer those taxes by reinvesting the proceeds in another qualifying property. Used repeatedly, it's one of the most powerful wealth-building tools available to real estate investors.
What qualifies
Since the Tax Cuts and Jobs Act of 2017, 1031 exchanges apply only to real property. Both the property you sell and the one you buy must be held for investment or for productive use in a trade or business. "Like-kind" is broad: you can exchange a rental house for an apartment building, raw land or a commercial property.
What doesn't qualify: your primary residence, a vacation home used mainly for personal purposes, and property held primarily for resale, such as a fix-and-flip.
The two deadlines you can't miss
- 45 days: from the day you close on the sale, you have 45 calendar days to formally identify potential replacement properties in writing.
- 180 days: you must close on the replacement property within 180 days of the sale, or by the due date of your tax return for that year (including extensions) if that comes earlier.
These deadlines generally aren't extended for weekends, holidays or deals that fall through, apart from narrow disaster-related relief. Many investors start lining up replacement options before they sell.
Identification rules
Most investors use the three-property rule, which lets you identify up to three properties of any value. Alternatives include the 200% rule (any number of properties whose combined value doesn't exceed 200% of the property sold) and the rarely used 95% rule.
You can't touch the money
If you receive the sale proceeds, even briefly, the exchange fails. A qualified intermediary (QI) holds the funds between the sale and the purchase. Choose your QI carefully. The funds are in their custody, so look for strong safeguards such as segregated accounts and fidelity bonding.
Avoiding "boot"
To defer all of the tax, you generally need to buy a property of equal or greater value, reinvest all of the net proceeds and replace the debt you paid off with new debt or added cash. Any cash you take out, or any reduction in debt that isn't offset, is called boot and is taxable.
Other things to know
- Your tax basis carries over from the old property to the new one, which affects future depreciation.
- Exchanges between related parties have special restrictions.
- You report the exchange on IRS Form 8824.
- Many states follow the federal rules, but some have their own reporting requirements.
- Under current law, heirs generally receive a stepped-up basis at death, which can eliminate the deferred gain entirely. That's why some investors "swap until they drop."
The bottom line
A 1031 exchange can keep far more of your equity working for you, but it's unforgiving of mistakes. Engage a qualified intermediary and a tax advisor before you list your property, and plan your replacement search around the 45-day clock.
