What a 1031 exchange is

The rule

Section 1031(a)(1) says that no gain or loss is recognized on the exchange of real property held for productive use in a trade or business or for investment if it is exchanged solely for real property of like kind that is to be held for either of those purposes. Each element carries weight: the property sold and the property bought must both be real property, both must be held for business or investment, and the transaction must be an exchange rather than a sale followed by an unrelated purchase.

An owner who meets those conditions and fully reinvests in real property pays no capital gains tax, no depreciation recapture and no net investment income tax on the sale in the year it happens (section 1245 recapture on some building components can still apply). The gain is not erased. Under section 1031(d) the replacement property takes the basis of the relinquished property, adjusted for any cash or debt difference, so the deferred gain reappears when the replacement property is eventually sold without another exchange.

What qualifies

Almost any real property in the United States held for investment or business use is like kind to any other. An apartment building can be exchanged for farmland, a warehouse for a tenant-in-common interest in an office building, a rental condominium for a leasehold with at least 30 years to run. The regulations look at the nature of the property, not its grade or quality.

Four categories are outside the rule:

• Personal property. The Tax Cuts and Jobs Act limited section 1031 to real property for exchanges after December 31, 2017. Equipment, vehicles and furniture no longer qualify, even when sold with a building.
• A primary residence. A home lived in by the owner is not held for investment. Section 121, the home-sale exclusion, is the relevant rule instead, and a property that has been both a residence and a rental can involve both sections. A home acquired through a 1031 exchange cannot use the section 121 exclusion if sold within five years of the exchange.
• Property held primarily for sale. Inventory, lots held by a developer and a house bought to renovate and resell are dealer property, not investment property.
• Foreign real property. Real property in the United States and real property outside it are not like kind to each other (section 1031(h)).

Whether a particular property is "held for investment" is a question of the owner's intent and the facts, and the Code sets no minimum holding period. That question is for the owner's tax advisor.

How a deferred exchange works

A direct swap between two owners is rare. Almost every exchange today is a deferred exchange under Treas. Reg. §1.1031(k)-1: the owner sells to one buyer, later buys from another seller (buying from a related party raises special rules), and a qualified intermediary holds the transaction together in between. The sequence is fixed.

1. Before the sale closes. The owner and the qualified intermediary sign a written exchange agreement. The owner assigns its rights under the sale contract to the intermediary, and the buyer is notified of the assignment. This must be in place before title transfers; an exchange cannot be started after the sale has closed. If a closing is imminent and no exchange is arranged, see last-minute 1031 exchanges.
2. At the sale closing. Title passes from the owner to the buyer, but the net proceeds are paid to the qualified intermediary, not to the owner. The day the sale closes is day zero.
3. Within 45 days. The owner identifies replacement property in a signed writing sent to a permitted recipient, usually the intermediary, following the identification rules.
4. Within 180 days. The owner closes on one or more of the identified properties. The intermediary is assigned into the purchase contract and wires the exchange funds to that closing. The 180 days end sooner if the owner's tax return for the year of sale is due first, unless the return is extended.
5. At tax time. The exchange is reported on Form 8824 with the return for the year the relinquished property was sold.

The owner never has the right to receive, pledge or borrow against the sale proceeds while the exchange is open. That restriction, set out in Treas. Reg. §1.1031(k)-1(g)(6), is what keeps the transaction an exchange rather than a sale. It is also why the qualified intermediary must be independent: the owner's own attorney, accountant, broker or agent within the previous two years is a disqualified person and cannot hold the funds, unless the only services were 1031 exchange services or routine title, escrow or banking services provided by a title company, escrow company or bank.

What is deferred, and what is not

An exchange defers the entire gain when the owner buys replacement property worth at least as much as the property sold, net of selling costs, and reinvests all of the equity. Three things break full deferral:

• Cash taken out. Any proceeds the owner receives, at the sale or at the end of the exchange, are taxable to the extent of the gain.
• Trading down. Buying replacement property worth less than the property sold produces boot equal to the shortfall, and gain is taxable up to that amount (but not more than the total gain).
• Debt relief. A mortgage paid off at the sale that is not replaced by new debt or additional cash on the purchase is treated as cash received.

These are all forms of boot. A partial exchange is still an exchange; the owner simply recognizes gain up to the boot received.

Why the timing matters

The two deadlines are the most common reason exchanges fail. Both periods run from the day the sale closes, at the same time, and both are counted in calendar days. There are no extensions for financing or other delays. The only postponements are IRS relief for federally declared disasters (Rev. Proc. 2018-58) and for service in a combat zone. Owners who begin looking for replacement property before the sale closes, rather than after, are the ones who reach day 180 with an exchange completed. The deadline calculator shows the dates for any closing date.

Variations

The deferred exchange described above is the forward exchange. Two variations handle other sequences. A reverse exchange lets the owner acquire the replacement property before selling, by parking one property with an exchange accommodation titleholder under Rev. Proc. 2000-37. An improvement exchange uses the same structure to build on or renovate the replacement property with exchange funds before the owner takes title. Both are more involved and more expensive than a forward exchange, and both use 45-day and 180-day periods, which in a reverse exchange run from the date the exchange accommodation titleholder takes title, under Rev. Proc. 2000-37.

Sources

• Internal Revenue Code §1031(a), (d) and (h).
• Treas. Reg. §1.1031(a)-1 (like-kind property) and §1.1031(k)-1 (deferred exchanges, identification, qualified intermediary safe harbor).
• Tax Cuts and Jobs Act, Pub. L. 115-97, §13303 (real property only).
• Rev. Proc. 2000-37 (reverse exchanges); Rev. Proc. 2018-58 §17 (disaster relief).
• IRS Form 8824 and instructions.