This guide covers—in very easy terms—Section 1031 exchange rules.
We’ve executed exchanges for 27+ years.
And our clients have deferred hundreds of millions of dollars in real estate taxes
Let’s get started.
Simple, easy terms.
Definitions, examples, IRS rules, strategies, and more.
Improving cash flow, changing asset classes, and receive stepped-up basis.
Learn what your Qualified Intermediary does.
Get tips and see which mistakes to avoid.
What property qualifies for a 1031 exchange?
The rules you have to follow to get full tax deferral.
One of those hidden rules.
Plus: Partnership and LLC issues.
This is often the hardest rule.
We guide you through your options.
See how to complete your exchange in time…
…and what happens with multiple properties.
These tax items will cost you money.
We tell you how to avoid them.
When to begin each step, how to handle the unforeseen.
We’ve executed exchanges for 27 years.
We’ll begin with a chapter on the basics.
And the “why it matters”
We’ll cover technical details later.
A 1031 Exchange (or “like-kind exchange”) allows real estate investors to defer their capital gains taxes (and other income taxes) when selling a property.
Investors must reinvest in another qualified asset.
The strategy comes from Section 1031 of the Internal Revenue Code.
You own a snowball that’s rolling downhill.
The snowball gets bigger as it rolls.
Unfortunately, there are sharp rocks at the bottom.
(Quick fact: Income taxes are often your largest cost when selling investment real estate)
Not good for you.
But what if you could put your snowball on top of a new hill instead of hitting the rocks?
That snowball keeps growing bigger, faster.
You get the point.
1031 exchanges can do this for your real estate.
You’ll hurdle right over HUGE tax bills.
And get tons of benefits.
Like-kind exchanges help you defer taxes so you can keep your gains working for you.
(We’ll show you how later)
No tax bill.
Your “snowball” just keeps growing!
Yes (see below)
Or at least that is the theory.
The good news?
You’ll earn extra income from a higher-profit property made affordable because you did a 1031 exchange.
The bad news?
You still paid taxes.
But, what if you keep exchanging?
Important: A 1031 exchange is not a magic pill. It doesn’t (by itself) erase your tax liabilities.
The IRS doesn’t let you off that easy.
And there is a time and a place for facing a tax event.
But for lots of investors, the ability to keep all of their gains is a game-changer.
If you invest in real estate — or if your business owns real estate — then 1031 exchanges should be in your toolkit.
Let’s talk about
↑ More buying power
↑ Way more flexibility
↑ Stronger estate planning
The Federal government taxes 15-20% on capital gains.
Most states take an extra 3-10%. It can get as high as 13.3% for California investors.
Conservatively, that’s 25% out of your pocket.
Remember: RE investors also face depreciation recapture (which has even higher rates)
You can purchase more — and/or better — real estate with extra capital.
Consider 25% more buying power.
After every deal.
Larger, more valuable properties generate (on average) higher returns.
After all, that’s why they are more valuable.
Let’s go further.
A 2015 NAR survey revealed that like-kind exchanges give entrepreneurs flexibility, particularly when they pursue “better economic use”.
In other words, a 1031 lets you change:
All without paying taxes.
This means more efficient capital deployment.
That NAR survey estimated 40% of all RE deals would not have occurred without a 1031 exchange.
And this makes complete sense.
Think about it:
Why switch to a new opportunity if doing so costs tens (or hundreds) of thousands in taxes? Again, taxes are often your greatest selling cost.
Key takeaway: Choosing when to face a large tax bill can be a HUGE advantage.
Here’s a cool thing:
The IRS built a backdoor in the Internal Revenue Code. And investors can use it to side-step capital gains taxes.
(Not sure if they meant to. But it’s there)
What is it?
It removes taxes on gains for assets inherited by your heirs, including:
Our clients are often very happy to hear this.
Particularly if they have kids!
The Tax Foundation explains this tax law:
Essentially, did your heirs inherit your property?
If yes, no capital gains tax carries over.
This leads to the expression — rather morbid — “Swap ‘til you drop.”
Here’s a simple breakdown of the strategy.
Talk with a 1031 specialist about your investment strategy. Cover more than a single transaction. Tell them about your long-term hopes. The good ones can help you get there.
Our company, 1031x, is a “Qualified Intermediary” or “QI”.
We help investors with tax-deferred exchanges across the United States.
As a QI, we:
A Qualified Intermediary helps taxpayers facilitate tax-deferred exchanges under Internal Revenue Code Section 1031. The formal rules for a QI are defined in Treas. Reg. §1.1031(k)-1(g)(4).
And what are those rules?
The Legal Information Institute wrote a solid, technical answer.
In other words:
The QI creates legal distance between you and your 1031 transactions by
And, since you are distanced from the sale and purchase…
…you’re also distanced from the taxes!
Technically, you want your QI to:
⇒ coordinate your sale(s)⇒ hold and safeguard your funds⇒ coordinate your purchase(s)
But it should also:
⇒ gather all relevant information⇒ guide you intelligently⇒ communicate with everyone
The IRS also puts restrictions on who can be your QI.
To review, the following CANNOT be your QI:
× Your agent
× Your broker
× Your attorney
× Your accountant
× Your investment banker
× Your real estate agent
× Your employee
× …anyone who fit those categories in the last 2 years
The IRS insists that taxpayers use QIs.
The original Section 1031 exchanges were direct, simultaneous asset swaps between two parties.
As time passed, it got more complicated.
Third parties joined in.
New rules piled up.
Investors — and regulators — grew confused. 😕
So, in 1991, “Safe Harbor” rules came out to clarify tax-deferred exchanges.
“Safe Harbor” is a technical term.
We like this definition by finance lecturer and CFA Adam Hayes.
Bottom line? If someone follows the Safe Harbor rules, the IRS rubber-stamps their exchange.
What is the most important Safe Harbor?
Using a Qualified Intermediary.
Here it is.
The most important part.
You automatically fail a 1031 if you touch your money.
Again, the LII explains.
So your QI holds the money instead.
In most cases, the QI contracts with an FDIC-insured bank to hold your funds in escrow
In most cases, the QI contracts with an FDIC-insured bank to hold your funds in escrow
For instance, 1031x provides our clients with an Exchange Agreement…
…that limits our client’s access…
…placing their funds in a “Qualified Escrow Account”…
…that requires dual authorization for any withdrawals.
We see some awful stories where a 1031 custodian tries to run off with their clients’ money.
In this case, “Atlantic Exchange” stole $132 million.
Atlantic Exchange was just one of many fraudulent subsidiaries of The 1031 Tax Group LLP.
It’s sickening to see.
Luckily, this bad guy got caught.
Now, not all 1031 companies are criminal.
But some take stupid risks.
For example, LandAmerica Financial Group tried risking their clients’ 1031 funds to make outside investments.
Then 2008 happened.
LandAmerica got crushed.
And clients lost $265 million.
No bailout, either.
This (and other similar cases) lead to several U.S. states passing stricter QI laws.
Examples of stricter QI laws include
But that’s not all.
Your QI must also protect against external threats.
Especially wire fraud.
In fact, the latest FBI Internet Crime Report showed real estate wire fraud was $221,365,911 in 2019.
That is up from $149,458,114 in 2018.
In other words, real estate wire fraud grew 48.11% in a single year!
This is why we encrypt our communication, verbally verify each wire, and stay up to date with the latest in wire fraud protection.
We take this VERY seriously.
You should too.
How do you spot a good QI?
Due diligence on your end is key.
You should look for
The last part is particularly important.
If they can’t answer your questions—or don’t even answer the phone!—then how do you know they’re right for you?
Luckily, modern technology makes this easier.
As with most things, Google is a good place to start.
Here you can see the company ratings.
And read reviews from new clients.
Or returning clients.
And check to see if the QI will look out for your best interest.
Rather than just up-selling you.
It’s OK to misspell “Sean”.
He’s still your friend.
After you find your QI and sell your relinquished property, you defer your taxes by trading into “like-kind” property.
This begs a question:
What is “like-kind” property?
It’s really, really simple.
In fact, Section 1.1031(a)-1 of the Treasury Regulations states:
“productive use in a trade or business”
“or for investment”
These are pretty loose.
In fact, the regulations mostly describe what is NOT like-kind real estate.
(Personal and vacation homes, mainly)
Almost everything else counts.
The IRS’ own website is even less precise:
Seriously. That’s it.
For instance, these are all like-kind to each other:
(This list is not exhaustive).
What is NOT like-kind property in a 1031 exchange?
Important note: Partnership interests are not like-kind to real estate. That means you can’t directly trade into or out of a percentage ownership of an LLC, for example.
There are strategies for successfully trading out of partnerships or an LLC.
And they’re often specific to your situation.
Contact directly for details.
Section 1031 says you only defer all of your taxes if you purchase enough replacement property.
But how much exactly? 🤔
At least replace what you sold!
This can get complicated.
(We’ll avoid using too much jargon)
There are two basic components:
Net equity is the amount a seller would walk away with at closing (absent a 1031).
It’s distinct from Gross equity. Mashvisor explains
Net sales price is the full contract price of the property after removing closing costs (commissions, etc.)
Investors that fail to meet either (or both) thresholds must pay taxes on the difference.
Key Takeaway #1: Use all net proceeds from the relinquished property towards down payment on replacement property.
Key Takeaway #2: Buy properties worth at least as much as what you sell.
You defer all your taxes.
You can’t change taxpayers during a 1031 exchange. The initial seller must be the same taxpayer when buying new property.
No adding names to title.
No taking names away.
Same entity the whole way.
The IRS allows just one way to report a like-kind exchange:
You must use IRS Form 8824.
Now, every property — relinquished and replacement — must report on the same 8824.
And there’s only one tax ID field.
(No, you can’t list multiple IDs or use two forms).
This can be a bummer.
It means you can’t add or remove taxpayers (i.e. no changes in vesting) during the 1031 process.
In fact, this isn’t even written into law.
Just a functional limitation.
Can property held by one spouse exchange for property held by both? (Or vice versa?)
The IRS is not very clear about this.
Under Section 1041, property transfers between spouses are tax-free.
So, can one spouse sell in their individual name… then add the other spouse (under Section 1041) to the replacement property?
Here are two safer options:
Add spouse to title of relinquished property BEFORE starting the 1031 exchange
Add spouse to title of replacement property AFTER ending the 1031 exchange.
Then there are the “community property” states.
In certain states, assets acquired during marriage belong to both spouses.
(Source: IRS Publication 555)
Gains and losses are shared, too.
Nine states maintain community property laws:
Spouses in these states can title everything jointly.
They can even switch title from one spouse’s individual name to their joint two-member LLC!
This is a BIG subject in tax-deferred exchanges.
“Tax Partnership” can mean either:
− State law partnership− Multi-member LLC
A lot of investors own real estate this way.
We’ve written about why it is a big hurdle when selling the relinquished property.
Here’s the rub.
Partnerships (intact) qualify for 1031 exchanges.
» They can sell and buy together, no problem.
× But members can’t exchange separately or change ownership during a 1031.
Always speak with your qualified intermediary before selling as a partnership.
Key Takeaway: Plan ahead. Make sure you sell and buy as the same taxpayer.
After you sell, the IRS requires that you officially identify (in writing) what you might buy next.
This is often the hardest part for our clients.
You only get 45 days after closing.
There are other restrictions, too.
In some cases, so-called 1031 “rules” are actually “best practices”
They are open to interpretation.
Not the 1031 deadlines.
These are set in concrete.
One concrete rule is the 45-day identification rule.
Here’s the process in a nutshell:
This must occur within 45 days of your sale (hence the name of the rule).
To make this easier, we have our clients use an interactive online ID form:
You’ll notice we offer only three ID spots.
That’s the IRS’ limit.
This is known as the 3 – Property Rule.
As long as you identify three or fewer, you can list properties of any value.
If you list more than three properties, the rules change.
Well, then you must either follow the:
Let’s say you sell a $750,000 duplex.
And you want to identify more than three properties using the 200% rule.
Well, the combined value of all identified properties cannot exceed $1,500,000 (or 200% of $750,000).
This is very limiting.
Especially since you want to trade equal or up in value.
…or you can try the 95% rule.
Let’s say you sell the same duplex for $750,000.
And you identify more than three properties. But their combined value is $3,000,000.
Well, you can still do a 1031 exchange if you purchase at least $2,850,000 of the identified value (or 95% of $3,000,000).
Stick with listing just three.
It’s much easier.
After you sell, the IRS gives you 180 calendar days to complete your 1031 exchange.
This is the other big deadline.
The IRS restricts 1031 exchanges to a 180-day period.
Starting when you sell, you have 180 calendar days to purchase and take title to your replacement asset(s).
The complexity of your 1031 exchange does not matter.
If you’re purchasing or selling multiple properties as part of the same exchange, you must meet the same 180-day period beginning upon sale of your first relinquished property.
The first sale always triggers the 180 days.
The last purchase must close before the end of those 180 days.
Get these ducks in a row.
Especially if you’re buying or selling multiple assets in the same 1031 exchange.
The term “boot” gets thrown around plenty in this industry.
It’s kind of a cool term.
Feels like old-fashioned vernacular.
But what does it mean?
(Hint: it’s not good)
As we explain in our Examples of “Boot” post
If you receive a “boot” item, you’re taxed on its value.
The most common 1031 boot item is cash.
Take out cash when you sell? It all becomes taxable. The same is true if you later receive cash from your 1031 escrow account.
Here’s an example.
That $50K instantly becomes taxable at the highest applicable rate.
It doesn’t matter what you do with the $50K.
Even if you replace the $50K when you purchase a replacement property, it’s still taxable.
The next most common kind of boot is debt relief.
Fail to replace the value of the mortgage on your relinquished property? That’s taxable too.
This is how it works.
Imagine you sell for $500K.
But only purchase for $400K.
This time, all of the equity went into the replacement property.
But you traded down by $100K.
Here’s what the IRS sees:
You Gave Up
Debt relief is not “like-kind” to real property.
(Pro Tip: You can replace the amount of debt by adding new debt on to your replacement property or bringing new outside cash to the deal)
For example, this is a completely tax-deferred 1031 exchange.
You could accomplish the same goal by simply increasing the principal on your new mortgage.
It REALLY helps to be organized if you want to pull this off without a hitch.
In fact, staying organized is often the difference between a smooth, stress-free (and tax-free!) exchange…
…or an exchange full of fits, starts, and panic.
We’ve seen taxpayers so disorganized that their exchange ended up failing.
It’s an expensive mistake.
And totally avoidable.
You are going to sell a commercial property.
The sale closes on March 1.
And your 1031 deadlines begin counting down.
A month passes quickly.
Then another week.
It’s April 9.
After a few frustrating days, you decide that you’re going to eat the taxes.
Now you owe the IRS more than $250,000 in capital gains taxes.
(And you haven’t even calculated your depreciation recapture)
This is not uncommon in the 1031 world.
(Pro Tip: Just google “[X] days from [sale date]”)
The answer pops right out.
You list properties that you’re interested in. Your QI helps you stay within the limits.
For example, the second property you list goes off the market on April 3.
“No problem!” says your QI.
“We’ll take that off the list and you still have until April 15 to identify a replacement.”
You enter into a contract to purchase one of your ID’d properties on June 4.
On July 1, the seller says they need to push up closing to July 8.
You close on a new $3.5M property July 8.
1031 exchange complete!
Now all of your gains keep working for you.
Onward and upward.
A good QI will process hundreds or thousands of exchanges each year. Rely on your intermediary to keep your exchange organized rather than tackling the IRS yourself.
We hope you enjoyed our 1031 exchange guide. Now we’d like to turn it over to you:
Or maybe you just want to provide better information to your own clients.
Either way, let us know.
– Comment on this page.
– Or email firstname.lastname@example.org.
Have questions about your exchange? Call us!
Our consultations are always 100% FREE
What happens if I am unable to find a suitable like-kind property within the 45 days?
Failure to identify within 45 days means that the 1031 exchange fails. There is no penalty for a failed 1031; you simply end up owing taxes as if you never attempted the exchange.
It’s really important that you begin your property search early doors — before you sell if at all possible!
Hi , can I buy a family residence to live in from the sale of a California rental property.
Jay, you cannot directly trade from a rental property into a personal residence through a 1031 exchange. However, there is an indirect way to do so. You purchase a replacement property that you eventually wish to occupy, treat it as an investment property for at least two years, then move in and declare it as a primary residence. So long as you wait two years, the IRS will not challenge or retroactively disallow the exchange. Clear?