Understanding a 1031 Exchange
The Internal Revenue Service and “Like-Kind Exchanges Under IRC Section 1031”
Some investors will even use the term as a verb, as in “Let’s 1031 that building for another.”
A 1031 exchange is when investors swap one real estate property for another that allows capital gains taxes to be deferred.
What does the IRS mean by “like-kind” property?
The IRS uses fairly vague language here, saying:
- Both properties must be similar enough to qualify as “like-kind”
- Like-kind property is property of the same nature, character, or class. Quality or grade does not matter.
Tax-deferred, not tax-free
A like-kind exchange under IRC Section 1031 is tax-deferred, not tax-free. In fact, we caution any investor to be very wary of real estate schemes that refer to “tax-free” exchanges.
The exchange can include like-kind property exclusively or it can include like-kind property along with cash, liabilities, and property that are not like-kind. If an investor receives cash or some kind of payment that is not like-kind, they may trigger some taxable gain in the year of the exchange. There can be both deferred and recognized gain in the same transaction when a taxpayer exchanges for like-kind property of lesser value.
Who qualifies for the Section 1031 exchange?
- Individuals
- C corporations
- S corporations
- Partnerships (general or limited)
- Limited liability
- companies
- Trusts
- And any other taxpaying entity may set up an exchange
of like-kind properties under Section 1031
Both properties in an exchange must be held for use in a trade or business, or for investment. Property, used primarily for personal use, like a primary residence, second home, or a vacation home does not qualify for like-kind exchange treatment.
What are the different structures of a Section 1031 Exchange?
Simultaneous exchange
A simultaneous swap of one property for another.
Deferred exchange
Allows the investor to dispose of property and subsequently acquire one or more other like-kind replacement properties. Both sides of the exchange must be mutually dependent parts of an integrated transaction. Exchange facilitators are usually involved to ensure IRS regulations are met.
Reverse exchange
Do 1031 exchanges have a time limit?
1
The investor has 45 days from the date they sell the relinquished property to identify potential replacement properties.
2
The replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier. The replacement property received must be substantially the same as the property identified within the 45-day limit described above.
Deferred and reverse 1031 exchanges have additional timeline rules, which is why it is particularly important for investors to work with a qualified, experienced facilitator.
1031 Exchange Checklist
You will need to provide the following to your QI as soon as you have a signed contract:
1. Property Information
- Relinquished Property Address: Full legal description and physical address
- Purchase & Sale Agreement: A fully executed copy of the contract for the property you are selling
- Title/Escrow Contact: Name, email, and phone number of the officer or attorney handling the closing
- Existing Loans: Payoff statements for any mortgages or liens
2. Taxpayer Information
- Entity Details: The name on the title (e.g., individual, LLC, Trust). The entity selling must be the same entity
buying the new property - Tax ID/SSN: Needed for the QI to set up a segregated escrow account for your funds
3. Financial Estimates
- Estimated Net Proceeds: Roughly how much cash will be left after paying off mortgages and closing costs
- Debt to be Replaced: The amount of the mortgage payoff (IRS rules require you to replace the value of the
debt you “relieved” yourself of)
Step-by-Step 1031 Exchange Process
Step 1: Engage the QI (Before Closing)
Once you have a buyer for your property, send the contract to the QI. They will draft an Exchange Agreement and an Assignment of Contract. This legally allows the QI to step into your shoes to receive the funds.
Step 2: Sale Closing (Day 0)
At the closing table, you sign a “Notice of Assignment” informing the buyer that the QI is handling the transaction. Crucially, the cash proceeds are wired directly to the QI’s secure account. If the money hits your personal bank account for even one second, the exchange is void.
Step 3: The 45-Day Identification Period
The clock starts the day you close your sale. You have exactly 45 calendar days to submit a written list of potential replacement properties to your QI.
- The 3-Property Rule: Most common; you can list up to three properties of any value.
- The 200% Rule: You can list more than three, as long as their total value doesn’t exceed 200% of what you sold.
Step 4: Contract for Replacement Property
When you find your new property, include “1031 exchange cooperation” language in the contract. Send this contract to your QI. They will draft assignment papers for the purchase side of the deal.
Step 5: Purchase Closing (Day 180)
You must close on your new property within 180 calendar days of your original sale (or your tax filing deadline, whichever is earlier). Your QI wires the held funds directly to the closing agent to complete the purchase.
Step 6: IRS Reporting
The following year, you (or your CPA) must file IRS Form 8824 with your tax return to officially report the exchange and the deferred gain.
