What is a 1031 Exchange and How Does It Work?
If you have ever considered selling an investment property and buying another one, you may have heard the term “1031 exchange.” A 1031 exchange is one of the most powerful tools available to real estate investors. It allows you to defer paying capital gains taxes on the sale of an investment property, as long as you reinvest the proceeds into a like-kind property.
In this post, I am going to walk you through what a 1031 exchange is, how it works, important timelines you must follow, and where you can learn more if you are thinking about using this strategy.
What is a 1031 Exchange?
A 1031 exchange gets its name from Section 1031 of the Internal Revenue Code. In simple terms, it allows an investor to sell a property, reinvest the proceeds in another property of equal or greater value, and defer the capital gains taxes they would normally owe.
This means you can keep more of your money working for you, instead of handing over a large portion to the IRS after every sale.
Basic Rules of a 1031 Exchange
To successfully complete a 1031 exchange, there are several important rules you must follow:
- The Properties Must Be Like-Kind
“Like-kind” does not mean identical. It simply means that both the old and the new properties must be held for investment purposes or for productive use in a trade or business. For example, you can exchange an apartment building for a retail center, or raw land for an office building. More information on like-kind properties can be found directly from the IRS. - You Must Use a Qualified Intermediary
You cannot take possession of the sale proceeds yourself. A neutral third party called a Qualified Intermediary (sometimes called an accommodator or facilitator) must hold the funds until they are used to purchase the replacement property. - You Have Strict Timelines
Timing is everything in a 1031 exchange. You have 45 days from the sale of your property to identify potential replacement properties. You must close on the new property within 180 days of selling the old one. These are calendar days, not business days. Missing these deadlines can disqualify your exchange. - You Must Reinvest the Entire Proceeds
To fully defer taxes, you must reinvest all of the sale proceeds into the new property. If you take any cash out, that portion will be taxed as a capital gain.
Common Uses of a 1031 Exchange
1031 exchanges are not just for large institutional investors. They are commonly used by everyday real estate investors who want to:
- Trade up from a small rental property to a larger one
- Consolidate multiple properties into one larger asset
- Diversify into different property types
- Relocate investments to different geographic areas
- Increase cash flow by moving into higher-yield assets
- Transition properties for estate planning purposes
Some investors even use multiple 1031 exchanges over time to build significant wealth while continuing to defer taxes. This strategy is sometimes referred to as “swap till you drop” because if the investor holds the final property until death, their heirs receive a step-up in basis and the deferred gains may be eliminated altogether.
What a 1031 Exchange Cannot Be Used For
There are limits to what qualifies for a 1031 exchange. Personal residences do not qualify. Vacation homes may qualify under very strict conditions, but generally, properties must be held for investment or business use. You cannot 1031 exchange stocks, bonds, or partnership interests. Only real property qualifies.
Key Steps to Completing a 1031 Exchange
If you are considering doing a 1031 exchange, here are the key steps you will need to follow:
- Plan Ahead: Meet with your real estate agent, CPA, and a Qualified Intermediary before you list your property. Make sure you understand the timelines and have a general idea of what you want to buy next.
- Hire a Qualified Intermediary: The Qualified Intermediary will prepare the necessary documentation and hold the sale proceeds during the process.
- Sell Your Relinquished Property: Complete the sale and make sure the funds are transferred to the Qualified Intermediary.
- Identify Replacement Properties Within 45 Days: Provide written identification of the properties to the Qualified Intermediary. You can identify up to three properties regardless of value, or more under certain rules.
- Close on the New Property Within 180 Days: Complete the purchase and finalize the exchange.
- File the Proper Tax Forms: When you file your taxes for the year of the exchange, you must complete IRS Form 8824.
Where to Learn More About 1031 Exchanges
For readers who want to dive even deeper into the rules and strategies around 1031 exchanges, here are a few trusted resources:
- IRS Like-Kind Exchanges Main Page
- Federation of Exchange Accommodators — A professional organization for Qualified Intermediaries
- 1031 Exchange Myth Busters
Your Next Step
Thinking about selling an investment property and wondering if a 1031 exchange is right for you? Start by talking with a trusted real estate professional and a tax advisor who understands the rules inside and out.
If you have questions about how 1031 exchanges work, or you would like to be connected with a Qualified Intermediary or experienced agent in your area, reach out today. I am here to be your unbiased guide through the real estate process, helping you make smart and confident decisions for your financial future.
