1031 Exchange Rules and Deadlines

What property qualifies

Section 1031 of the Internal Revenue Code says no gain or loss is recognized when real property held for productive use in a trade or business or for investment is exchanged solely for real property of like kind that will also be held for business or investment. A few rules follow from that sentence:

• Only real property. Since 2018, section 1031 applies to real property only; equipment, vehicles and other personal property don't qualify.
• Business or investment use, both sides. A rental or an office building qualifies; a home you live in doesn't, and neither does the home you buy to live in.
• Not property held for sale. The rule doesn't apply to real property held primarily for sale, such as homes a developer or flipper builds or renovates to sell.
• U.S. for U.S. Real property in the United States and real property outside it are not like kind.

Within those limits, “like kind” is broad for real estate. The Form 8824 instructions say properties are of like kind if they are of the same nature or character, even if they differ in grade or quality, and that real properties generally are of like kind whether they are improved or unimproved.

The 45-day and 180-day deadlines

In a deferred exchange you sell first and buy later. Two deadlines, both counted from the day the sale of your property closes, decide whether the replacement is treated as like-kind property at all. You must identify it by midnight on the 45th day, and receive it by midnight on the earlier of the 180th day and the due date, including extensions, of your return for the year of the sale. Property identified or received late isn't like-kind property, and the gain is taxed.

The return due date catches sales late in the year: a sale on November 20 reaches its 180th day after the April 15 due date of that year's return, so unless you extend the return, the deadline comes early. The 1031 exchange calculator works out both deadlines for your closing date.

How to identify replacement property

Identification has to be in writing, signed by you, and delivered by the 45th day to a person involved in the exchange other than you or a disqualified person, such as the intermediary. The regulations limit how much you can identify:

• up to three properties of any value; or
• any number of properties whose total value is no more than 200% of the property you sold.

Identify more than that and it is treated as if you identified nothing, unless you actually acquire at least 95% of the value of everything you identified. Property you acquire before the 45th day counts as identified.

Never touch the money: qualified intermediaries

If you receive the sale proceeds, or can draw on them, the exchange fails for that money. A qualified intermediary solves this: a person who isn't you or a disqualified person (such as your agent) enters into a written exchange agreement with you, takes the sale proceeds, and acquires and transfers the replacement property to you under the agreement. Arrange the intermediary before the sale closes; once you have the cash, it is too late.

Boot: what makes part of the gain taxable

Anything you receive that isn't like-kind property is boot, and gain is recognized up to the boot. Cash left over after the purchase is cash boot. Debt relief is boot too: if the mortgage paid off on the property you sell is larger than the mortgage on the replacement plus the cash you add, the difference is mortgage boot.

In the calculator's example, a $600,000 rental with a $250,000 adjusted basis and a $200,000 mortgage is exchanged for a $650,000 property with a $300,000 mortgage, leaving $14,000.00 of cash boot and $14,000.00 of recognized gain; $300,000.00 is deferred. Buying a $500,000 replacement with a $200,000 mortgage instead would recognize $64,000.00. To defer everything, buy at least as much property, with at least as much debt or added cash, and take no cash out.

Related parties, basis and reporting

• Related parties. If you exchange with a related person and either of you disposes of the exchanged property within 2 years of the last transfer, the deferral is lost, with the gain taken into account when that disposition happens.
• Basis carries over. The deferred gain reduces the replacement property's basis, so it is taxed when you eventually sell without exchanging. In the example, the $650,000 replacement has a basis of $350,000.00.
• Reporting. The exchange is reported on Form 8824 for the year you transfer your property, which works out the realized, recognized and deferred gain and the new basis.

If a sale without an exchange is the better choice, the rental property capital gains tax calculator estimates the tax it would cost, so you can compare the two.

Common ways an exchange fails

Each of the rules above is a way to lose the deferral. The most common ones are simple:

• A missed deadline. Identification after the 45th day, or a closing after the 180th day or the unextended return due date, turns the replacement into a taxable purchase.
• Touching the proceeds. Taking the sale money, or having the right to it, before the replacement closes. A qualified intermediary has to be in place before the sale.
• The wrong kind of property. A replacement you will live in, property held mainly for resale, or real estate outside the United States for property inside it.
• A related-party sale. Either side selling the exchanged property within 2 years.
• Unplanned boot. Cash left over or a smaller mortgage on the replacement doesn't end the exchange, but it makes part of the gain taxable now.

Before you list the property, line up the intermediary, decide what you might buy, and run the numbers so you know how much you need to spend and borrow to defer everything.