Putting off the Tax Collector – The Basics of 1031 Exchanges

Welcome to the first installment of this four-part series on 1031 exchanges, where we explore how investors can make use of the tax advantages offered by 1031 exchanges. 

Reinvest Your Capital and Enjoy Tax Advantages

How does a 1031 exchange benefit investors? One of the consequences of selling an appreciated investment is the assessment of taxes on any capital gains.

Capital gains tax applies to all kinds of property, including stock, collectibles, or real estate. Fortunately, Section 1031 of the Internal Revenue Code (IRC) provides a safe harbor enabling real estate investors to defer payment of capital gains tax, as well as the recapture of tax deductions taken for depreciation and Affordable Care Act taxes, if they promptly replace the property sold with ‘like-kind’ assets.

These transactions are called 1031 exchanges, and they apply specifically to business or investment real estate.

Below is an overview of the 1031 exchange rules and the process for receiving the tax benefits.

An Overview of the 1031 Exchange Rules

Section 1031 of the IRC provides: “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment.”

This rule dates back to 1921, and was rooted in the situation where one party was literally swapping their real estate with another directly:

Before the exchange:

• Party A owns Blackacre, and Party B owns Whiteacre. The parties exchange properties with one another directly.

After the exchange:

• Party B owns Blackacre, and Party A owns Whiteacre.
• No money changes hands, and the IRS does not collect taxes from either party.
• Party A’s cost basis in Whiteacre is the same as her original cost basis in Blackacre, and vice versa for Party B.

These days, it is uncommon for two parties to trade property solely between themselves. Rather, an owner sells property to one person in exchange for a different person’s property:

Before the exchange:

• Party A owns Blackacre, Party B owns Whiteacre, and Party C owns Redacre.
• Party A sells Blackacre to Party B and acquires Redacre from Party C as replacement property.

After the exchange:

• Party A owns Redacre, Party B owns Blackacre plus Whiteacre, and Party C gets cash.

Here, Party A has completed a valid tax-deferred exchange. Assuming that Redacre is worth the same or more than Blackacre, Party A does not pay tax on her gains in connection with the transaction. Party A’s tax basis in Redacre carries over from Blackacre, regardless of the purchase price of Redacre or the sale price of Blackacre.

What Qualifies as ‘Like-Kind’ Property?

The definition of like-kind is construed very broadly for real estate. Almost all real estate is considered ‘like-kind’ to all other real estate, so long as it is not being used personally by the exchanging party. As such, a commercial building may be exchanged for any of the following:

• A rental apartment.
• Farmland.
• A long-term ground lease.
• Oil and gas royalties.
• A different commercial property.
• A fractional property interest as a tenant-in-common.
• A fractional property interest as a beneficiary of certain types of trusts i.e., Delaware statutory trusts (DST) or Illinois land trusts.

Not all fractional ownership interests will qualify for an exchange. Shares in a REIT, membership interests in an LLC, or partnership interests in a partnership that owns a property are considered personal property for 1031 purposes and cannot be exchanged. Before you list your property for sale, speak with your accountant or tax advisor to confirm that both your property for sale and your intended replacements are eligible for an exchange.

Carrying Over the Investor’s Tax Basis

Assuming all of the 1031 rules are strictly followed, the investor’s tax basis in the sold property will carry over to the replacement property. The capital gains tax, depreciation recapture, and Affordable Care Act taxes that ordinarily would be assessed at the time of sale will instead be levied when the replacement property is sold. Investors can repeatedly exchange properties in this manner, continuing to defer tax until either the property is sold without completing an exchange or the taxpayer dies (colloquially referred to as ‘swap till you drop’) and the heirs receive a step up in basis.

Both individuals and entities are eligible to do a 1031 exchange. While a membership interest in an LLC or partnership cannot be exchanged under IRC 1031, an LLC or partnership that owns property can do an exchange at the entity level. If you own a property with others who do not wish to exchange, or if your co-investors wish to buy different replacement property than you do, it is important to speak with a legal or tax advisor to help you structure a solution.

Keep in mind that 1031 exchanges only apply to certain federal taxes. Local taxes, such as transfer taxes, are not deferred under 1031. Most states will allow you to defer payment of state-level capital gains taxes with a valid 1031 exchange, but there are exceptions. California, Oregon, Massachusetts, and Montana, for example, all have clawback provisions, whereby they may assess state capital gains taxes in the future when you eventually sell your replacement property.

How To Get Your Tax Benefits

So, how can you avail yourself of this tax benefit?

Step #1: Get a Qualified Intermediary

To get started, you will first need a qualified intermediary (QI), also known as an exchange accommodator, to hold your sale proceeds for the duration of the exchange transaction. You will enter into a contract with the QI, assigning the QI your right to receive the sale proceeds to effectuate an exchange.

QI companies are often affiliated with banks or title companies that handle segregated accounts, and most intermediaries have a background in law or tax. The QI should not be related to the exchanging party. There is no required licensing for intermediaries, but the trade association for the QI industry offers a Certified Exchange Specialist (CES) designation for professionals who have passed a series of exams to establish their knowledge of the exchange rules and regulations. Having a QI is critical, because any sale proceeds disbursed directly to the investor cannot be part of the 1031 exchange.

Ideally, you should engage a QI before you enter into a contract to sell your property. The QI or your attorney will provide language to be included in the purchase and sale contract to indicate that an exchange is taking place. All parties to the transaction must receive notice of the exchange.

Step #2: Sale of Your Property

In a traditional ‘forward’ exchange, the sale of your ‘relinquished property’ will happen first. [i] When you close, the QI will hold all of your net sale proceeds until you are ready to acquire your replacement property.

In the example above, the funds would move like this:

1. Party A assigns her contract rights to receive sale proceeds to the QI.
2. Party A sells Blackacre to Party B. Party B pays for the property, and the sale proceeds are delivered to the QI for Party A’s benefit rather than directly to Party A.
3. The QI holds Party A’s sale proceeds. When Party A is ready to acquire Redacre from Party C as replacement property, QI delivers the funds to Party C in exchange for Redacre.
4. Party A now owns Redacre and has deferred her tax from the sale of Blackacre. The QI returns any unused funds to Party A at the end of the exchange period.

Step #3: The Identification Period

You then have 45 days from the date your sale closes to identify potential replacement properties. This is called the identification period. You may identify multiple replacement properties, either together or in the alternative.

The rules give you flexibility to either identify up to three potential replacement properties of any value (the ‘three property rule’), or more than three properties with an aggregate value of up to 200% of the value of what you sold (the ‘200% rule’). You can also identify a property by purchasing it outright during your identification period. [ii]

All properties must be identified with specificity, including the nature of the interest (i.e., fee simple, fractional interest, ground lease), a street address or legal description, and the fair market value.

Going back to the example above, let’s assume that Party A sells Blackacre for $1 million.

The ‘3 Property Rule’ identifies one or more of any of the following prospective replacement properties:

• Redacre, 1407 Graymalkin Lane, Salem Center, NY (FMV = $1.2 million).
• Whiteacre, 220 East 42nd Street, Manhattan, NY (FMV = $950,000).
• Blueacre, 1007 Mountain Drive, Gotham City, NJ (FMV = $1.1 million).

Party A can purchase any or all of Redacre, Whiteacre, or Blueacre to complete her exchange. However, if she only acquires Whiteacre, she will pay tax on the gain attributable to the $50,000 price difference between Blackacre ($1 million) and Whiteacre ($950,000).

The ‘200% Rule’ identifies one or more of any of the following prospective replacement properties:

• 50% beneficial interest in Redacre DST, 1407 Graymalkin Lane, Salem Center, NY (FMV = $600,000).
• Whiteacre, 220 East 42nd Street, Manhattan, NY (FMV = $950,000).
• 25% tenant-in common interest in Blueacre, 1007 Mountain Drive, Gotham City, NJ (FMV = $275,000).

• Greenacre, 123 Main Street, Hooterville, CA (FMV = $175,000).

Note that the fair market value (FMV) must be specified to ensure you are not exceeding the 200% threshold.

The identification of replacement property technically can be made to any party to the exchange, but the best practice is to identify your replacement property to the QI.  The QI then prepares paperwork that allows you to establish on your tax return that you completed an exchange in accordance with IRC 1031.

The identification must be made by no later than 45 calendar days after the sale of the relinquished property.

Step #4: Acquiring the Replacement Property

You have a total of 180 calendar days after your sale (an additional 135 days after your identification period) to actually acquire any replacement property from the list of options you identified.

These deadlines are strictly enforced. It does not matter if your date falls on a weekend or holiday — if you fail to act within the deadline, or if you are unable to purchase any of the properties on your identified list, you will lose the benefits of the exchange. [iii]

Identifying alternative replacement properties is a good practice, and there is no extra cost to do so. The 1031 deadlines go quickly, and it is helpful to give yourself options that allow you to pivot instead of paying taxes if your first-choice property falls through.  Additionally, if you are planning to acquire less than the entirety of a property, such as in the examples above with a tenancy in common or DST interest, or ground leaseholds or mineral rights, you must acquire substantially the same interest as what you identify.  A 25% interest in a $1 million property ($250,000) would not be considered substantially the same as a 75% interest in that same property ($750,000).

Understanding ‘Boot’

In order to completely defer your taxes in a 1031 exchange, the value of all of the replacement property you ultimately acquire must be greater than or equal to the value of what you just sold.

It is possible to exchange a property for something less expensive, but if you do so, you will have to pay the tax attributable to the difference in price between the old property and the new property. This difference is referred to as taxable ‘boot’. Any portion of your sale proceeds that comes directly to you instead of your QI will also be taxable boot, even if your replacement property is of greater value than the property you relinquish.

Note that the value of both your relinquished property and any replacement property includes the amount of any mortgage debt. Many people get confused by this point. As a rule of thumb, use the price your buyer pays you as the value of the relinquished property and the price you pay your seller(s) as the value of the replacement property. Whether some or all of the funds come from a mortgage loan is not important for 1031 exchange purposes.

Here’s an example. If you have a $500,000 mortgage on your property, and you sell it for $1.5 million, your replacement property must be worth at least $1.5 million, even though you only receive $1 million in cash proceeds after your lender is paid.

If you want to completely defer your taxes, you will either have to buy replacement property with mortgage loans of at least $500,000 or contribute $500,000 of outside cash to supplement the $1 million available in your QI account. In this example, your replacement property may be another $1.5 million (or greater) property, two $750,000+ properties, or even three $500,000+ properties. As noted above, the rules permit you to identify alternatives in case one or more of your options does not work out.

If you buy replacement property costing less than the value of your relinquished property, you will pay tax on the difference — i.e. the taxable ‘boot’. Accordingly, it is prudent to buy slightly more expensive replacement property than what you sold to completely defer your taxes, as some transaction costs and reserves may be ineligible for the exchange under the IRC. Whatever you choose, you must acquire all of your replacement property within 180 days of your initial sale. Any proceeds not reinvested in the 180-day exchange period will be returned to you, and you will be subject to any taxes due on that amount.

The Bottom Line To Making 1031 Exchanges

As noted above, the 1031 exchange rules are very specific, and this article merely provides an overview. Mistakes can result in you owing tax that you intended to defer.

One rule that isn’t part of the tax code is perhaps the most important: always consult your accountant or a knowledgeable tax advisor before undertaking any 1031 exchange.

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Real Estate Investing 101
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3. Business Borrowing Basics

This article was originally published on November 8, 2019.]

©2025. DailyDAC^TM, LLC d/b/a/ Financial Poise^TM. This article is subject to the disclaimers found here.

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Author’s Notes

[i] There are also ‘reverse’ exchanges where you buy your replacement property first.

[ii] There is also a ‘95% Rule’ that allows you to identify as much property as you want, but you must acquire at least 95% of what you identify.

[iii] The IRS does sometimes grant a narrow exception in the case of federally declared disasters, such as major storms. In that case, the IRS will offer a postponement of the 45 or 180-day deadlines if the taxpayer, the relinquished property, or a party to the exchange is in the federally-declared disaster area, making it difficult for the taxpayer to complete the exchange in the originally-prescribed time.  The extensions offered are specific to each disaster; consult with your tax advisor or QI if you believe you may be an affected taxpayer.