A 1031 exchange—named after Section 1031 of the Internal Revenue Code—is a powerful tax-deferral strategy used by real estate investors. This provision allows you to sell one investment property and reinvest the proceeds into another like-kind property, while deferring capital gains taxes. However, it’s essential to follow the IRS rules carefully to qualify for the benefits. Here’s everything you need to know about how a 1031 exchange works for investment properties.
What Is a 1031 Exchange?
A 1031 exchange allows real estate investors to defer paying capital gains taxes on an investment property when it is sold, so long as another like-kind property is purchased using the profits from the sale. The purpose is to promote reinvestment and continued growth within the real estate market.
Basic Rules of a 1031 Exchange
Like-Kind Properties
The IRS requires that the properties involved be of “like-kind.” This doesn’t mean they have to be identical, but they must be of the same nature or character.
Examples of qualifying exchanges:
Vacant land for a rental home
An apartment building for a retail strip mall
A duplex for a single-family rental
Does not qualify:
Primary residence (personal use)
Fix-and-flip properties (typically considered inventory, not investment)
Properties held for resale (dealer property)
Investment or Business Use Only
Both the property sold (relinquished property) and the property bought (replacement property) must be held for investment or productive use in a business. Personal residences, second homes, or properties used primarily for personal enjoyment do not qualify.
Timeline Rules
Strict timing requirements apply:
45-Day Identification Rule: You have 45 calendar days from the sale of your relinquished property to identify potential replacement properties. The identification must be in writing and submitted to the Qualified Intermediary (QI).
180-Day Exchange Rule: The exchange must be completed within 180 days from the date of the original sale—not 180 days from the property identification.
These timeframes run concurrently, meaning you must close on the replacement property within 180 days, not 225.
Use a Qualified Intermediary (QI)
You cannot touch the proceeds of the sale. The funds must be held by a Qualified Intermediary, sometimes referred to as an accommodator. If you take possession of the funds—even temporarily—the IRS considers it a taxable event.
Equal or Greater Value Rule
To fully defer capital gains taxes, the replacement property must:
Be of equal or greater value than the relinquished property
Use all the net proceeds from the sale
Take on equal or greater debt (or offset any reduction in debt with cash)
Failing to meet these criteria can result in boot, which refers to cash or other non-like-kind property received in the exchange and is taxable.
Property Identification Rules
You can identify multiple replacement properties under specific rules:
Three-Property Rule: You may identify up to three properties regardless of value.
200% Rule: You may identify more than three properties, as long as their total fair market value does not exceed 200% of the relinquished property's value.
95% Rule: If you exceed the above limits, you must acquire 95% of the total value of all properties identified.
Same Taxpayer Rule
The taxpayer who sells the relinquished property must be the same taxpayer who acquires the replacement property. If you own the property under an LLC or trust, the same entity must acquire the new property.
Holding Period
While there’s no specific IRS-mandated holding period, you must hold both the relinquished and replacement properties for investment or business purposes. Generally, a safe period is at least two years before and after the exchange to avoid IRS scrutiny.
Special Considerations
Depreciation Recapture
While capital gains taxes may be deferred, depreciation recapture taxes can still apply if you don’t continue to reinvest in like-kind property.
State Laws
Some states have their own rules for 1031 exchanges or may not conform with federal treatment. Consult with a tax advisor familiar with your state.
Reverse and Construction Exchanges
Investors can also do:
Reverse Exchanges: Purchase the replacement property before selling the relinquished one.
Construction/Improvement Exchanges: Use exchange funds to improve a replacement property (must be completed within the 180-day window).
These types of exchanges are more complex and should be structured with experienced legal and tax advisors.
The 1031 exchange is one of the most effective tools available to real estate investors for building long-term wealth and deferring taxes. However, its rules are strict, and any misstep can trigger a taxable event. Working with a qualified intermediary, a real estate attorney, and a tax advisor is crucial to ensuring compliance.
If you're considering a 1031 exchange, planning ahead is key. Know the timelines, choose your replacement properties wisely, and follow the regulations to take full advantage of this tax-deferral strategy.
