In this article
A 1031 exchange works by trading real property held for business or investment for other real property of like kind, so that the gain on the property given up is not recognized at the time of the trade but carried into the property received. In its usual form, the owner sells through a qualified intermediary, names the replacement property in writing within 45 days and receives it within 180 days, without ever taking possession of the sale proceeds.
This article covers federal income tax in the United States, under section 1031 of the Internal Revenue Code. It is general information, not legal or tax advice. State income tax treatment is a separate question and is not covered here.
The word to hold on to is deferral. The Internal Revenue Service states in its 2008 fact sheet on like-kind exchanges that the gain is postponed, not forgiven, and it lists the description of an exchange as "tax-free" among the warning signs of an improper scheme. The worked example below is computed in dollars and states no tax rate, since the rate depends on the owner.
Illustrative worked example detailed below; amounts in US dollars, computed the way Form 8824 computes them.
What is a 1031 exchange?
A 1031 exchange is an exchange of real property held for productive use in a trade or business or for investment, solely for real property of like kind to be held for the same purposes, on which section 1031 of the Internal Revenue Code says no gain or loss is recognized.
Two points sit inside that sentence. There must be an exchange, not a sale followed by an unrelated purchase: the Internal Revenue Service describes the sale and the purchase as parts of one integrated transaction. And the rule works in both directions: a loss is not recognized either, which matters to an owner whose property has fallen in value.
The provision has been limited to real property since 2018. According to the Internal Revenue Service, the Tax Cuts and Jobs Act restricted section 1031 to real property with effect from January 1, 2018, so that exchanges of machinery, equipment, vehicles, artwork, collectibles, patents and other intangible business assets no longer qualify. Individuals, corporations, partnerships, limited liability companies and trusts may all exchange, according to the Internal Revenue Service's fact sheet.
What property qualifies, and what does not?
Real property held for business or investment qualifies for a 1031 exchange, and real property is like kind to other real property whether it is improved or unimproved; property held primarily for sale, a personal residence and real property outside the United States do not qualify. "Like kind" refers to the nature or character of the property, not to its grade or quality.
The Internal Revenue Service gives a rental house and vacant land as an example of two properties that are like kind to each other. What cannot change is the purpose for which the owner holds the property.
| Property | Qualifies? | Why |
|---|---|---|
| Rental house, apartment building, office, warehouse | Yes | Real property held for investment or business use |
| Vacant land held as an investment | Yes | Improved and unimproved real property are like kind |
| Homes built or lots subdivided to be sold | No | Section 1031 excludes real property held primarily for sale |
| Primary residence, second home, vacation home | No | Not held for business or investment, according to the Internal Revenue Service |
| Real property outside the United States | No, against US property | The statute says the two are not like kind |
| Equipment, vehicles, artwork, patents | No | Not real property; excluded since 2018 |
| Stocks, bonds, notes, most partnership interests | No | The Form 8824 instructions list them as never real property |
What counts as real property is defined in the Treasury regulations. The instructions to Form 8824 summarise that definition as land and improvements to land, unsevered natural products of the land, and water and air space above the land. Each distinct asset is analysed separately, which is why a building sold with its furniture or equipment needs care: the same instructions disregard personal property that is incidental to the replacement real property only when it is of a kind typically transferred with it and its total value does not exceed 15% of the value of that real property.
How does a deferred exchange work?
A deferred exchange works by having the owner transfer the property given up first and receive the replacement property later, within fixed time limits, under an exchange agreement with a qualified intermediary who takes the place of the owner in both transfers. It is the common form of a 1031 exchange, because two owners who each want the other's property at the same moment are rare.
The vocabulary comes from the Treasury regulation on deferred exchanges, section 1.1031(k)-1: the property given up is the relinquished property, the property acquired is the replacement property, and the owner is the taxpayer.
- Sign the exchange agreement before the sale closesThe owner and a qualified intermediary sign a written exchange agreement, and the owner's rights under the sale contract are assigned to the intermediary. The agreement must expressly limit the owner's right to receive, pledge or borrow the money.
- Transfer the relinquished propertyThe sale closes. The net proceeds go to the qualified intermediary, not to the owner. This is day 0: both periods start here.
- Identify the replacement property by day 45The owner names the candidate properties in a signed written document delivered before midnight on the 45th day.
- Contract for the replacement propertyThe owner signs the purchase contract and assigns it to the intermediary, so that the intermediary is treated as acquiring the property and transferring it to the owner.
- Receive the replacement property by day 180The intermediary pays the exchange funds into the purchase and the owner takes title, by the 180th day or the due date of the tax return for the year of the transfer, whichever is earlier.
- Report the exchange on Form 8824The form is filed with the tax return for the year in which the relinquished property was transferred.
A simultaneous swap, in which two deeds change hands at the same closing, still exists and is the simplest structure in the Internal Revenue Service's description.
Why must the seller not receive the sale proceeds?
The seller must not receive the sale proceeds because an owner who has the money, or has the right to take it, has sold the property rather than exchanged it. The Internal Revenue Service warns that taking control of cash or other proceeds before the exchange is complete may disqualify the entire transaction and make all of the gain taxable immediately.
The Treasury regulation states the rule in terms of actual and constructive receipt. Actual receipt is the money arriving in the owner's hands; constructive receipt is wider. The regulation treats money as received when it is credited to the owner's account, set apart for the owner or otherwise made available to draw on. An owner who leaves the proceeds with a closing agent but can ask for them at any time is in constructive receipt.
The regulation offers safe harbors, arrangements under which the owner is treated as not being in receipt of the money. Cash may be held in a qualified escrow account or a qualified trust, or the exchange may run through a qualified intermediary, which is the usual route. In each case, the agreement must expressly bar the owner from receiving, pledging, borrowing or otherwise obtaining the benefit of the money before the end of the exchange period.
That bar has two exits written into the regulation. If nothing has been identified by the end of the identification period, the owner may have the money after that date, and the transaction is then a taxable sale. If property has been identified, the owner may have what remains once all the replacement property the owner is entitled to has been received.
Who can act as the qualified intermediary?
A qualified intermediary is a person who is neither the taxpayer nor a disqualified person and who, under a written exchange agreement, acquires the relinquished property, transfers it to the buyer, acquires the replacement property and transfers it to the taxpayer. The Treasury regulation treats an assignment of the owner's rights under each contract as enough, which is why the deed usually passes directly between the owner and the other party.
The limit on who may serve is strict. According to the Internal Revenue Service's fact sheet, an owner cannot act as their own facilitator, and neither can the owner's agent: the fact sheet names the owner's real estate agent or broker, investment banker or broker, accountant, attorney and employee, and anyone who has worked for the owner in one of those capacities within the previous two years.
That rule shapes the roles at the table. The owner's attorney advises on the exchange; the closing or settlement agent conducts each closing and disburses according to the settlement statement; the qualified intermediary holds the exchange funds in between. The sale proceeds travel from the first closing to the intermediary, stay there, and are sent by the intermediary into the second closing, with only what is left over returning to the owner.
The Internal Revenue Service notes that some intermediaries have declared bankruptcy or failed to meet their contractual obligations, and that a deadline missed for that reason can cost the owner the deferral. Asking how the exchange funds are held, in whose name and under what controls is ordinary diligence when choosing an intermediary, and established intermediaries answer those questions readily.
How long do you have: the 45-day and 180-day periods
The identification period ends at midnight on the 45th day after the relinquished property is transferred, and the exchange period ends at midnight on the 180th day after that transfer or on the due date, including extensions, of the tax return for the year of the transfer, whichever comes first. Both periods start on the same day and run together, so the owner has 180 days in total, not 45 plus 180.
The days are calendar days, counted from the transfer. On a relinquished property transferred on March 10 of a year that is not a leap year, the identification period ends on April 24 and the exchange period on September 6.
The return due date is the part that catches owners who close late in the year. When the 180th day falls after the date on which the return for the year of the transfer is due, the exchange period stops at that due date unless the owner has obtained an extension of time to file.
Neither deadline is extended for hardship. According to the Internal Revenue Service's fact sheet, the 45-day and 180-day limits cannot be extended for any circumstance or hardship, except in the case of presidentially declared disasters.
A replacement property received before the 45th day is treated as identified, so an owner who closes the purchase within the first 45 days has no identification to draft.
How do you identify replacement property?
Replacement property is identified in a written document signed by the taxpayer that describes the property unambiguously and is delivered, before the end of the identification period, to the person obliged to transfer the replacement property or to another person involved in the exchange who is not a disqualified person. In practice the notice goes to the qualified intermediary.
The Internal Revenue Service is explicit that notice to the owner's own attorney, real estate agent or accountant is not sufficient. For real property, the regulation accepts a legal description, a street address or a distinguishable name. An identification can be revoked in the same manner until the period ends, and not after.
How many properties may be named is governed by three rules in the regulation, of which the owner needs to satisfy one.
| Rule | What may be identified | Condition |
|---|---|---|
| Three-property rule | Up to three properties | No limit on their value |
| 200% rule | Any number of properties | Their total fair market value does not exceed 200% of the value of the relinquished property |
| 95% rule | Any number, any value | The owner actually receives properties worth at least 95% of the total identified |
Take the relinquished property of the worked example, sold for $1,400,000. Under the three-property rule the owner may name three properties of any price. Under the 200% rule the owner may name more than three, provided their combined value stays at or under $2,800,000. An owner who names five properties at $900,000, $800,000, $700,000, $600,000 and $500,000 has identified $3,500,000, which fails both rules; that identification holds only if the owner goes on to receive at least $3,325,000 of those properties, which is 95% of the total. Otherwise the regulation treats the owner as having identified nothing, apart from any property already received before the 45th day.
The property finally received must be substantially the same as the property identified, and the regulation applies that test to each property separately.
What is boot, and how is it taxed?
Boot is the trade name for money or property that is not like kind received in an exchange, and section 1031 makes the owner's gain taxable up to the amount of boot received. The statute itself speaks of "money" and "other property".
Boot does not disqualify the exchange. According to the Internal Revenue Service, cash, debt relief or non-like-kind property can trigger taxable gain, but only up to the value of those proceeds, and the exchange still qualifies.
Boot takes two main forms.
- Cash boot is money the owner takes out: exchange funds not spent on the replacement property and returned at the end, or proceeds paid to the owner at the first closing.
- Mortgage boot is debt relief. The statute says that when another party assumes a liability of the taxpayer, the assumption is considered money received by the taxpayer.
The Treasury regulation on the assumption of liabilities, section 1.1031(d)-2, sets the netting rules, and they are not symmetrical. Liabilities the owner takes on with the replacement property offset the liabilities the owner is relieved of. Cash the owner adds to the purchase also offsets debt relief. But new debt does not offset cash received: an owner who pulls cash out of the exchange has boot in that amount, however large the new loan is.
A full deferral therefore requires reinvesting all of the net proceeds and replacing the debt paid off with new debt or with added cash. As to the character of the gain, the instructions to Form 8824 note that part of the recognized gain may have to be reported as ordinary income under the depreciation recapture rules, with the rest reported as capital gain or as gain on business property, depending on what was exchanged.
How are the gain and the new basis calculated?
The calculation takes five figures in order: the gain realized, the boot received, the gain recognized, which is the smaller of those two, the gain deferred, which is the difference, and the basis of the replacement property, which is its value less the deferred gain. The example below is illustrative, in US dollars, and follows the lines of Form 8824.
The assumptions are these. An owner bought a small commercial building for $800,000 and has claimed $200,000 of depreciation, leaving an adjusted basis of $600,000. The building sells for $1,400,000. Exchange expenses, meaning the commissions and closing costs of the sale, come to $60,000, and the $500,000 mortgage is repaid at closing. The qualified intermediary therefore receives $840,000. The gain realized is the same whatever the owner buys next: $1,400,000, less $60,000 of expenses, less the $600,000 basis, which is $740,000.
Two replacement purchases are compared. In the first, the owner trades down to a $1,200,000 property with a new $400,000 loan, so only $800,000 of exchange funds is needed and $40,000 is returned to the owner. In the second, the owner trades up to a $1,500,000 property with a new $660,000 loan, which uses the whole $840,000.
| Line | Trade down | Trade up |
|---|---|---|
| Replacement property price | $1,200,000 | $1,500,000 |
| New loan | $400,000 | $660,000 |
| Exchange funds used | $800,000 | $840,000 |
| Cash returned to the owner | $40,000 | $0 |
| Net debt relief ($500,000 repaid, less new loan) | $100,000 | $0 |
| Boot received | $140,000 | $0 |
| Gain realized | $740,000 | $740,000 |
| Gain recognized | $140,000 | $0 |
| Gain deferred | $600,000 | $740,000 |
| Basis of the replacement property | $600,000 | $760,000 |
In the trade down, the owner ends with $40,000 in hand and $100,000 less debt, and that $140,000 is the gain recognized in the year of the exchange. The treatment of the repaid mortgage as a liability the owner was relieved of, offset by the new loan, follows the netting described in the form's instructions and in the regulation; an adviser confirms it on the facts of the actual loans. The $60,000 of expenses paid out of the proceeds does not create boot, because the form's instructions let exchange expenses reduce the cash and other property received.
What is carry-over basis?
Carry-over basis means that the replacement property does not take its purchase price as its tax basis: it takes the basis of the property given up, decreased by any money received, increased by any gain recognized and by any additional consideration the owner paid. This is how the deferred gain is preserved rather than erased.
The worked example shows both checks. In the trade down, the old basis of $600,000, plus $140,000 of gain recognized, less $140,000 of boot received, gives $600,000; the same figure comes from the $1,200,000 price less the $600,000 of deferred gain. In the trade up, where nothing comes back to the owner and the new loan exceeds the old one by $160,000, the old basis of $600,000 plus that $160,000 of additional debt gives $760,000, which is also the $1,500,000 price less the $740,000 of deferred gain.
Two consequences follow, and both are noted by the Internal Revenue Service. The depreciable basis of the replacement property is generally lower than it would have been after a taxable purchase, so future depreciation deductions are smaller. And when the replacement property is eventually sold outside an exchange, the deferred gain becomes taxable along with any further gain: sold for exactly its $1,200,000 purchase price, with depreciation set aside for simplicity, the trade-down property would show a $600,000 gain, the amount deferred earlier.
For that reason the basis computation is kept with the property's records for as long as the property is owned.
How is a 1031 exchange reported on Form 8824?
A 1031 exchange is reported on Form 8824, Like-Kind Exchanges, filed with the tax return for the year in which the relinquished property was transferred, even when the replacement property is received in the following year. The form is where the dates are declared and the gain and basis are computed.
| Part of Form 8824 | What it records |
|---|---|
| Part I | Descriptions of the property given up and received, the date of written identification and the date the replacement property was received |
| Part II | Whether the exchange was made with a related party, and whether either side has since disposed of the property |
| Part III | Boot received, gain realized, gain recognized, gain deferred and the basis of the like-kind property received |
The dates entered in Part I are the ones the 45-day and 180-day tests are measured against, a reason to keep the signed identification notice and both settlement statements.
Related parties get their own part because the statute treats them differently. Under section 1031, when the exchange is made with a related person and either party disposes of the property it received within two years of the last transfer, the deferral is lost, subject to exceptions such as a disposition after a death or one that did not have tax avoidance as a principal purpose. The instructions require the form to be filed again for the two years following the year of a related-party exchange.
How do reverse and improvement exchanges work?
A reverse exchange acquires the replacement property before the relinquished property is sold, and an improvement exchange uses exchange funds to build on or improve the replacement property before the owner receives it.
In a reverse exchange the owner cannot simply buy the new property and sell the old one afterwards, since the owner would then hold both. The Internal Revenue Service's answer is a safe harbor, Revenue Procedure 2000-37, under which the property is "parked" with an exchange accommodation titleholder in a qualified exchange accommodation arrangement. According to the Internal Revenue Service's fact sheet, the titleholder holds the property for no more than 180 days, during which the owner disposes of the relinquished property to close the exchange. The revenue procedure states that it is a safe harbor only and draws no conclusion about parking arrangements that fall outside it.
An improvement exchange, also called a build-to-suit or construction exchange, rests on the part of the deferred exchange regulation that deals with property to be produced. The regulation allows replacement property that does not yet exist, or is still being built, to be identified: the land by its legal description and the construction in as much detail as is practicable. The limit is what the owner has received by the end of the exchange period. Real property still under construction counts only to the extent of the land and the completed work, and the regulation says in terms that work performed after the owner receives the property is not like-kind property. Improvements paid for after the owner takes title are therefore not part of the exchange.
