1031 Exchange

Selling a rental or other investment property at a profit normally triggers capital gains tax in the year of sale. Section 1031 lets you instead exchange it for other real property of like kind and recognize no gain or loss, as long as both the property you give up and the one you receive are held for productive use in a trade or business or for investment.

Like-kind is broad for real estate. An apartment building can be exchanged for vacant land, a warehouse or a single-family rental, because improved and unimproved real property are generally of the same nature. The main exceptions: US real estate isn’t like-kind to real estate abroad, and property held primarily for sale, such as a house bought to fix and flip, doesn’t qualify. Since the Tax Cuts and Jobs Act took effect in 2018, only real property counts; equipment, vehicles, artwork and other personal property no longer do.

Your main home is excluded, and so is a second home used mainly for personal purposes, although a rental with limited personal use can still qualify under an IRS safe harbor. Most exchanges today are deferred rather than simultaneous swaps: you sell first, a qualified intermediary holds the money, and you buy the replacement within strict deadlines. In a reverse exchange you buy first, and an exchange accommodation titleholder holds the new property for up to 180 days while you sell the old one.

A deferred exchange runs on two clocks that start the day you transfer the property you sell. You must identify the replacement property in writing within 45 days, and you must receive it by the earlier of 180 days or the due date, including extensions, of your tax return for the year of the sale. Miss either and the gain is taxable. The deadlines count calendar days and can’t be extended for hardship; the main exception is relief the IRS announces after a federally declared disaster.

The identification must be signed and delivered to the seller of the replacement or another party to the exchange, such as the intermediary, not to your own attorney or agent. It must describe each property clearly, by legal description, street address or distinguishable name. You can name up to three properties of any value, or any number whose total value is no more than 200% of the property you sold. If you exceed both limits, the identification can still stand if you acquire at least 95% of the value of everything you named.

The return due date can cut the 180 days short. A sale in November reaches April 15 before its 180th day, so file an extension if you need the full period.

You can’t touch the sale proceeds. If you take actual or constructive receipt of the cash before the exchange is complete, the whole gain can become taxable. The usual safe harbor is a qualified intermediary that holds the money and completes both legs. You can’t be your own intermediary, and neither can a related person or anyone who has acted as your agent, broker, accountant, attorney or employee within the previous two years.

Anything you receive that isn’t like-kind real property is boot, and your gain is taxed up to the value of the boot. Cash left over after buying the replacement is boot, and so is net debt relief: if the mortgage paid off on the property you sell exceeds the debt on the one you buy plus any cash you add, the difference counts as money received. To defer all the gain, buy property of equal or greater value, reinvest all the cash and replace the debt. A loss is never recognized.

Your basis in the replacement starts from the old property’s adjusted basis rather than the price you pay. That carryover basis holds the deferred gain, including all the depreciation you claimed, so future depreciation starts from a lower number.

A taxable sale is simpler and frees the cash, but the gain lands in one year: up to 25% on the depreciation portion, 0%, 15% or 20% on the rest as long-term capital gains, possibly the 3.8% net investment income tax, and state income tax. A fully taxable sale also releases any suspended passive losses.

Exchanging keeps all your pre-tax equity invested, but you stay in real estate, with less diversification, ongoing management work and illiquidity. Repeating exchanges and then holding the last property until death can make the deferral permanent, because heirs receive a step-up in basis to market value.

A former home that became a rental can sometimes use two breaks at once. If you lived in it two of the five years before the exchange, the home sale exclusion applies first and Section 1031 defers the rest, including the depreciation gain. The reverse doesn’t work quickly: replacement property must be held for investment, so you can’t convert it to your home right after the exchange, and a home acquired through one can’t get the Section 121 exclusion until you have held it five years.

Many failed exchanges break on a procedural detail rather than on the property itself, and the result is the same: the entire gain becomes taxable in the year of the sale, with no way to restart the clock. Because the intermediary has to be in place before the sale closes, line up the intermediary, the replacement search and the financing before you list the property, not after an offer arrives.