1031 exchange: What it is, how it works, and key rules for real estate investors

Section 1031 is a provision in the tax code that can offer immense value to real estate investors and other real property owners. In a 1031 exchange, you essentially swap one real estate property for another — and by doing so, defer capital gains taxes on the sale of the first property.

Tax advisors often take advantage of this provision as a tool to benefit their clients. If you’re curious how it works and whether a 1031 exchange might be a useful method to advance your own business interests, keep reading to learn more about the process.

What is a 1031 like-kind exchange?

A 1031 like-kind exchange is a way to defer capital gains on real estate property sales.

Typically, when you sell any real property, you owe capital gains taxes on the sale. These are due for the tax year in which you sold the property and can often be substantial.

A like-kind exchange defers that tax burden. By selling a property and then quickly using the proceeds to acquire another property, you can largely defer paying capital gains taxes indefinitely.

What is section 1031 of the Internal Revenue Code?

Section 1031 of the Internal Revenue Code (IRC) is a federal tax provision that allows real estate investors to defer paying taxes on the sale of a property used in their trade or business or for investment.

How a 1031 exchange defers real estate capital gains

With a 1031 exchange, any proceeds from a real property sale can be reinvested into a like-kind property of equal or greater value without paying tax at the time of sale.

Reinvesting the proceeds allows an investor to roll over their basis into a new asset which defers the recognition of the gain until that new property is sold.

What “like-kind” property means in a 1031 exchange

The IRS generally defines like-kind as any real property held for investment or business use. The key requirement is that both the relinquished and replacement properties are held for productive use in a trade, business or investment and not as a primary residence or for personal use.

How does a 1031 exchange work?

To qualify for capital gains deferment via a 1031 exchange, you have to structure the sale process to meet certain specific rules, including but not limited to:

• You must exchange real property for other real property.
• You must identify a new property to acquire within 45 days.
• You must complete the exchange and take possession of your newly acquired property within 180 days.
• Generally, all funds from your real property sale must be held by a qualified intermediary (QI) until the exchange is complete. Think of a QI as performing a function that’s similar to an escrow account.
• You can’t take cash out from the deal by increasing the amount of debt in the new property without possible tax consequences.

Step-by-step: The 1031 exchange transaction process

From a high level, the typical 1031 process is fairly straightforward. Here are the key steps:

1. Identify an exchange property: Before you sell a real property, look for properties you’d consider exchanging it for. Ideally, you should evaluate multiple properties to give yourself options to choose from before settling on one to buy.
2. Meet with your tax advisor: Let your tax advisor know you’re considering a 1031 and run through the specifics of your situation to make sure you proceed correctly in order to satisfy all the requirements needed to defer capital gains.
3. Sell your current property: Complete the sale of your existing real property. You’ll use a QI to take and hold all funds from the sale until the exchange process is complete.
4. Acquire a new property within 180 days of your sale: Ideally, you’ve already identified a new property to acquire. But if you haven’t, you must do so within 45 days of the sale and complete the acquisition within 180 days.

Many 1031 transactions follow the basic structure outlined above. However, more complicated situations may necessitate a more nuanced approach here.

For example, let’s say you’re partnered with other investors on a joint investment property that you all want to sell. However, while you want to do a 1031 with the proceeds from your half of the property, one partner wants to cash out.

In this situation, you can’t just proceed with a straightforward 1031. Instead, you’ll need to work with your tax advisor to pursue more intricate deal structures that would allow both you and your partner to achieve your goals for the transaction.

Timeline rules

A rushed or unplanned 1031 also means you’re more likely to make a mistake, which could expose you to unexpected tax balances due.

The key parts of the 1031 exchange timeline are:

• You must identify a new property to acquire within 45 days.
• You must complete the exchange and take possession of your newly acquired property within 180 days.

You should always plan a 1031 ahead of time. Because you have to satisfy such specific requirements to successfully defer capital gains ­­— including a ticking clock — you don’t want to wait until you’ve already sold your property to begin.

The role of qualified intermediary (QI)

A qualified intermediary is a third-party entity that handles the logistics of a 1031 exchange. Under IRS guidelines, the QI acts as a neutral middleman to ensure the investor never gains constructive receipt of the sale proceeds, which would immediately trigger capital gains taxes.

In addition to facilitating the purchase, the QI plays a legal role in helping prevent construction receipt and tracking the timeline.

1031 exchange rules every real estate investor should know

A successful 1031 exchange depends on strict compliance with IRS requirements. Here are some core rules investors should understand before entering an exchange:

Eligible property: investment vs. personal use real estate

The IRS only permits 1031 exchange treatment for property held for investment or productive use in a trade or business. Your primary residence, a second home you use regularly or a vacation property you occupy does not qualify.

Like-kind requirement explained

In a 1031 exchange, like-kind refers to the nature of the property, not its type or quality. This means a residential rental property can be exchanged for a commercial building, a strip mall for raw land or a single-family rental for a multifamily property — all generally qualify.

Reinvestment rules to fully defer capital gains

To defer 100% of capital gains in a 1031 exchange, the IRS requires that you reinvest all net proceeds into the replacement property and acquire a property of equal or greater value than the one you sold. If either condition falls short, the difference, known as “boot,” becomes taxable in the year of the exchange.

Same taxpayer rule and ownership considerations

The same taxpayer rule requires that the taxpayer who sells the relinquished property be the same taxpayer who acquires the replacement property.

How long do you have to complete a 1031 exchange?

The IRS imposes two non-negotiable deadlines that govern the timeline of every 1031 exchange. The investor has exactly 45 calendar days to identify potential replacement properties in writing. The investor must then close on the replacement property within 180 calendar days of the sale of the relinquished property — not 180 days from the identification deadline.

Types of 1031 exchange transactions

There are several types of 1031 exchange structures, each designed to accommodate different transaction timelines and investor circumstances.

Deferred (forward) 1031 exchange

A deferred exchange is the most commonly used 1031. It allows an investor to sell the relinquished property first and identify a replacement property within 45 days, before closing on it within 180 days.

Reverse 1031 exchange

With reverse 1031 exchanges, an investor purchases a replacement property prior to selling their relinquished property.

This structure is useful in competitive markets where waiting to sell first risks losing the target property. However, these are more complex 1031 exchanges and expensive to execute, as the replacement property must be held by an exchange accommodation titleholder until the relinquished property sells.

Improvement (built-to-suit) exchange

This type allows the investor to use exchange proceeds to fund improvements on the replacement property before taking title. It is used when the replacement property is of lesser value than the relinquished property, and improvements are needed to meet the equal or greater value requirement.

Benefits of a 1031 exchange for real estate investors

A 1031 is a powerful tool for property owners to defer capital gains taxes. As long as you have proper counsel from a tax advisor, most 1031s are not particularly complex, and many real estate investors regularly use the provision.

To see the full benefits of your deferred capital gains, a careful analysis is typically needed to determine the validity of a 1031 exchange. It is important to analyze the cost of the exchange itself as well as how it fits into your own personal tax situation.

For instance, you may have net operating losses (NOLs) or capital losses. In this situation, it may make more sense to use those losses rather than invest in property that isn’t the ideal fit.

Common 1031 exchange mistakes to avoid

Even experienced investors can jeopardize a 1031 exchange through procedural missteps or planning oversights. The most common mistakes include:

• Missing deadlines: The IRS generally does not grant extensions of the 45-day identification or 180-day closing periods.      
• Taking constructive receipt of proceeds: Touching the sale proceeds before they reach a qualified intermediary disqualifies the exchange. 
• Misidentifying replacement properties: Identification must follow strict IRS rules on the number and value of properties named.
• Ignoring boot: Failing to account for cash or debt differences results in an unexpected tax bill.
• Changing ownership structure mid-exchange: Changing ownership violates the same taxpayer rule and can void the exchange. 
• Using a disqualified intermediary: A qualified intermediary cannot be your attorney, accountant, agent or anyone with a prior financial relationship with you.

How Wipfli can help

We advise real estate investors on transactions and taxes. Ask our team to help you strengthen your tax strategy and implement tools like 1031s that may defer or reduce your tax exposure. Learn more here.

Read more

• Succession in real estate: 9 best practices leaders use
• How the OBBB just changed taxes for real estate investors
• How to tackle more complicated 1031 exchanges