1031 Exchange

What is a 1031 Exchange?

A 1031 Exchange is a tax-deferral strategy authorized under Section 1031 of the U.S. Internal Revenue Code. It allows real estate investors to defer capital gains taxes when they sell an investment property, as long as the proceeds are reinvested into a “like-kind” property of equal or greater value. This strategy is commonly used to preserve equity and grow a real estate portfolio without immediate tax consequences.

Often referred to as a like-kind exchange, the 1031 Exchange has been a tool for real estate investors for nearly a century. It enables them to shift investments into new properties that better align with their financial goals—such as increasing cash flow, diversifying locations, or upgrading asset classes—while deferring the tax hit from capital gains.

According to IRS, IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.

Key 1031 Exchange Rules and Requirements

Although flexible in strategy, 1031 Exchanges must follow strict IRS rules. Failure to comply can result in a failed exchange (full tax liability) or a partial exchange (partial tax due). The IRS allows these exchanges to encourage continued reinvestment in real estate for business or investment purposes, not for personal gain.

Here are the seven core rules every investor should understand:

1. Exchange Setup Must Happen Before the Sale - You must initiate the 1031 Exchange before selling your property. A Qualified Intermediary (QI) must be used to handle the transaction and hold the sale proceeds in escrow.
2. Only Like-Kind Properties Qualify - Both the relinquished and replacement properties must be “like-kind,” meaning they are of the same nature or character, even if they differ in grade or quality. All real estate held for investment or business use generally qualifies.
3. Replacement Property Must Be Equal or Greater in Value - To fully defer taxes, the replacement property must be of equal or greater value, and all the sale proceeds must be reinvested.
4. Boot Is Taxable - Any cash or non-like-kind property received in the transaction (called “boot”) is subject to capital gains tax and/or depreciation recapture.
5. Taxpayer Must Remain the Same - The individual or entity that sells the relinquished property must be the same one that acquires the replacement property.
6. Follow strict identification for a 1031 exchange to the letter:
   • Three-Property Rule: Identification of up to three properties regardless of the total value of property identified
   • 200% Rule: Identification of any number of properties wherein the combined FMV (fair market value) does not exceed 200% of the relinquished properties' FMV
   • 95% Rule: Identification of any number of properties regardless of the aggregate FMV, as long as at least 95% of the  property is ultimately acquired.
7. Types of Properties Commonly Used in 1031 Exchanges
   • Agricultural Land & Farmland
   • Commercial Property
   • Investment Property
   • Vacation Rental Property (Airbnb & Vrbo)
   • Conservation Property
   • Timberland Investment Property
   • Oil
   • Gas
   • Mineral
   • Water and Ditch Rights
   • DSTs
   • REITs
8. You can exchange:
   • Real property: This includes buildings and land, both commercial and residential.
   • Investment property: This applies to properties held for generating income, such as rental properties.
9. You can not exchange:
   • Personal property: This includes your primary residence, personal use vacation homes, and other personal belongings.
   • Intangible property: This includes stocks, bonds, and other financial instruments. This does not apply to DSTs and REITs as these are tied to real property. Additionally, the IRS prohibits any “economic benefit” to the investor during the exchange. This includes receiving any proceeds from the sale or reducing mortgage liability without replacing it with a new liability or equivalent equity in the replacement property.

Time-Sensitive Deadlines

The IRS enforces two critical timelines for a valid 1031 Exchange:

• 45-Day Identification Period: Investors must identify potential replacement properties within 45 calendar days of selling the relinquished property.
• 180-Day Completion Window: The exchange must be fully completed—that is, the new property must be purchased—within 180 calendar days of the sale.

Missing either of these deadlines may disqualify the transaction from 1031 treatment, resulting in full tax liability.

Key Benefits of a 1031 Exchange

The primary advantage of a 1031 Exchange is the deferral of capital gains taxes on the sale of investment property. This includes federal and state capital gains taxes, depreciation recapture tax, and Net Investment Income Tax. Unlike other types of investments, only real estate held for investment or business use qualifies under Section 1031 of the Internal Revenue Code—making it a powerful tax-saving strategy exclusive to real estate investors.

In addition to tax deferral, there are several other important benefits:

• Preserve and Reinvest All Equity: By deferring taxes, investors can reinvest 100% of their sale proceeds into a new property. This maximizes purchasing power and helps grow long-term wealth more efficiently.
• Eliminate Capital Gains for Heirs: If the investor holds the replacement property until death, their heirs can benefit from a step-up in cost basis—potentially eliminating the deferred capital gains tax liability altogether.
• Diversify or Reduce Risk: A 1031 Exchange can be used to diversify an investment portfolio. For example, investors can trade a single high-value asset for multiple lower-risk properties or properties in different regions to spread exposure.
• Transition into Passive Investments: Investors who are tired of active property management can exchange into passive real estate vehicles like Delaware Statutory Trusts (DSTs), which provide steady income without the day-to-day responsibilities of property management.
• Access New Markets or Property Types: Like-kind rules are broadly defined for real estate, allowing investors to shift from one type of property to another (e.g., from land to multifamily, or from residential rentals to commercial property) and even into different geographic markets across the U.S.

Types of 1031 Exchanges

There are several variations of 1031 Exchanges, each with unique rules and use cases:

1. Simultaneous Exchange - This is the original structure used when 1031 Exchanges were first introduced. Both the sale of the relinquished property and the purchase of the replacement property happen on the same day. While rare today, it may still be used in simple one-to-one swaps, though it requires perfect coordination.
2. Delayed (Forward) Exchange - The most common type of exchange, a Delayed Exchange allows the investor to sell their current property first and then acquire a replacement property within a 180-day window. The investor must identify potential replacement properties within 45 days of the sale. This structure provides flexibility and time to find suitable replacement investments.
3. Reverse Exchange - In a Reverse Exchange, the investor acquires the replacement property before selling their existing property. This is useful when the ideal investment becomes available before the current property can be sold. However, it is more complex and typically requires an Exchange Accommodation Titleholder (EAT) to temporarily hold the new property.
4. Improvement or Build-to-Suit Exchange - This type allows the investor to use exchange funds to improve or build on a replacement property. The improvements must be completed and the property received by the investor within the 180-day exchange window. It’s ideal for those looking to customize or upgrade the replacement property.
5. Partial Exchange - In a Partial Exchange, the investor only reinvests part of the proceeds and keeps some cash (referred to as “boot”). While this allows some liquidity, any boot received is taxable and reduces the overall deferral benefit.

How to Execute a 1031 Exchange

Use these eight essential steps as a checklist:

1. Preparing for a 1031 Exchange - Preparing for a 1031 Exchange means getting everything in order before you sell your property. A bit of planning goes a long way in helping you defer taxes and avoid mistakes.
2. Consult with a qualified tax advisor and intermediary - Before you begin, speak with a tax advisor and a qualified intermediary. They’ll help you understand how the exchange works, whether it’s right for you, and what steps to follow so everything stays IRS-compliant.
3. Determine if you qualify - Not all properties or situations qualify. Your property must be used for investment or business (not personal use), and you must exchange it for another “like-kind” property. Be aware of potential taxes, like depreciation recapture, that may apply even if you qualify.
4. Research Replacement Properties - Start exploring potential replacement properties as early as possible. You’ll need to identify them quickly once your current property sells, so having options lined up ahead of time helps avoid rushed decisions.
5. Strict timelines - You only have 45 days to identify a replacement property and 180 days to close on it after selling your current property. Missing either deadline can disqualify the exchange, so it’s important to stay organized and on schedule.
6. Documentation - Keep detailed records of every step—sale agreements, identification forms, communications with your advisor and intermediary, and closing documents. This protects you if questions come up later.
7. Different exchange structures - There isn’t just one way to do a 1031 Exchange. Depending on your situation, you might do a delayed exchange (most common), a simultaneous one (buy and sell at the same time), or a reverse exchange (buy before you sell). A professional can help you pick the best option.
8. Tax implications - Even with a 1031 Exchange, you might still owe taxes on cash received during the deal (called “boot”) or depreciation recapture. Your tax advisor can help you understand what to expect based on your specific case.

Five parties participate in a DST/TIC offering for a 1031 exchange:

1. Sponsor – a real estate firm with experience in acquiring, managing and divesting commercial properties
2. Lender – a major institutional lender
3. Attorney – a specialist in 1031 exchanges and real estate transactions
4. Broker/Dealer – a FINRA, SIPC member securities brokerage
5. Investor – an accredited individual, trust, partnership, LLC, S corporation, and/or C corporation. 

Ownership Structures for 1031 Exchanges

Two common legal structures allow multiple investors to co-own real estate that qualifies for a 1031 Exchange:

• Delaware Statutory Trust (DST): Passive investment structure that qualifies as “like-kind” real estate.
• Tenancy in Common (TIC): Each investor holds an undivided fractional interest in the property.

Dos and Don’ts

✅ Dos: Best Practices for a Successful 1031 Exchange

• Plan Ahead - Successful 1031 Exchanges begin with proper planning. This includes evaluating your equity and debt replacement targets to avoid “boot” (taxable proceeds), understanding key deadlines, and retaining a qualified intermediary (QI) experienced in exchange processes.
• Sell Before You Buy (If Possible)- Ideally, the relinquished property should be sold before acquiring the replacement. If circumstances require buying first, a reverse exchange may be necessary. This involves temporarily parking either the replacement or relinquished property with an Exchange Accommodator Titleholder for up to 180 days, as outlined in IRS Revenue Procedure 2000-37.
• Use the “Napkin Test” to Stay Tax-Deferred • This informal test helps you assess whether your exchange will be fully tax-deferred: • Trading down in total property value? You may owe taxes on the difference. • Trading down in equity (i.e., taking out cash)? That portion may also be taxable.

❌ Don’ts: Common Pitfalls to Avoid

• Don’t Miss Key Deadlines • The IRS strictly enforces exchange timelines: • 45 days to identify replacement property. • 180 days to complete the purchase of the replacement. • Missing either deadline disqualifies your exchange and results in a taxable event.
• Don’t Change Title Structure Mid-Exchange - Avoid altering ownership entities or dissolving partnerships during the exchange. Doing so can violate the required holding period and disqualify the transaction.

Risks to Consider

While 1031 Exchanges offer powerful tax-deferral benefits, they come with certain risks:

• Strict Rules: Failure to meet identification or closing timelines can invalidate the exchange.
• Regulatory Uncertainty: There are no guarantees that:
• The IRS will approve every exchange.
• Future changes in tax law won’t impact your benefits.
• IRS guidance won’t evolve in ways that alter current interpretations.

Disclaimer

The information provided in this article is for educational purposes only and should not be considered legal or tax advice. Always consult with a qualified tax professional or attorney before proceeding with a 1031 Exchange or any other tax-related strategy.