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A 1031 exchange allows investors to sell property and defer capital gains taxes by reinvesting proceeds into similar property. Named after Section 1031 of the Internal Revenue Code, this strategy lets investors preserve equity and grow portfolios without immediate tax consequences. Strict rules govern timing, property types, and procedures. Understanding requirements before selling is essential.

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How 1031 Exchanges Work

Instead of selling property and paying capital gains tax, investor “exchanges” one investment property for another of equal or greater value.Taxes are deferred, not eliminated. Basis carries forward to new property. Taxes become due when eventually selling without another exchange.
  • Defer federal capital gains tax (15-20%)
  • Defer depreciation recapture tax (25%)
  • Defer Net Investment Income Tax (3.8%)
  • Defer state capital gains tax (varies)
On a property with $200,000 gain, taxes deferred could exceed $50,000.
Deferred taxes remain invested, compounding over time. Investors can exchange repeatedly throughout their lifetime.At death, heirs receive stepped-up basis, potentially eliminating deferred gains entirely.

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Requirements

Both properties must be “like-kind,” meaning real property held for investment or business use.Like-kind includes exchanges between:
  • Rental house for apartment building
  • Vacant land for commercial building
  • Industrial property for retail property
  • Single property for multiple properties
Property type, quality, or location don’t affect like-kind status. Real estate for real estate qualifies.
Both relinquished (sold) and replacement (purchased) properties must be held for productive use in trade, business, or investment.Qualifies:
  • Rental properties
  • Commercial properties
  • Vacant land held for investment
  • Property used in business
Does not qualify:
  • Primary residence
  • Second home (personal use)
  • Property held primarily for resale (flips)
  • Inventory
To defer all taxes, replacement property must be:
  • Equal or greater in value than property sold
  • Equal or greater in equity (value minus debt)
  • All proceeds must be reinvested
Receiving cash or reducing debt creates taxable “boot.”
Cannot touch sale proceeds. Must use qualified intermediary (QI) to hold funds between sale and purchase.If you receive proceeds, even briefly, exchange is disqualified.
Primary residences and second homes do not qualify for 1031 exchanges. Property must be held for investment or business use. Converting personal property to rental before selling has specific requirements and holding period considerations.

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Timeline Requirements

Strict deadlines apply. Missing them disqualifies the exchange.
Must identify potential replacement properties in writing within 45 days of closing on relinquished property.Identification rules (choose one):
  • 3-property rule: Identify up to 3 properties regardless of value
  • 200% rule: Identify any number of properties with combined value not exceeding 200% of relinquished property
  • 95% rule: Identify any number if you acquire 95% of identified value
Most investors use 3-property rule for simplicity.
Must close on replacement property within 180 days of closing on relinquished property.Or by tax return due date (including extensions) for year of sale, if earlier.The 180 days includes weekends and holidays. No extensions except in limited disaster situations.
  • January 15: Close on sale of relinquished property
  • March 1: 45-day deadline to identify replacement (January 15 + 45)
  • July 14: 180-day deadline to close on replacement (January 15 + 180)
If selling late in year, tax return deadline may be earlier than 180 days.
Calendar deadlines are strict. If day 45 falls on a weekend or holiday, it is still the deadline. Plan identification well before deadline to avoid last-minute problems.

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Types of Exchanges

Most common type. Sell relinquished property first, then purchase replacement within 180 days.QI holds proceeds between transactions.
Both properties close on same day. Rare in practice due to coordination challenges.Still requires QI to avoid constructive receipt of funds.
Purchase replacement property before selling relinquished property. More complex and expensive.Requires Exchange Accommodation Titleholder (EAT) to hold title to one property.Must identify relinquished property within 45 days of acquiring replacement. Must close sale within 180 days.Useful in competitive markets where waiting to sell first risks losing desired property.
Use exchange funds to improve replacement property before taking title.EAT holds title while improvements made. Improvements must be complete within 180 days.Allows exchanging into property that needs work, with improvements funded by exchange proceeds.

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Qualified Intermediaries

  • Holds sale proceeds in escrow
  • Prepares exchange documents
  • Ensures proper documentation
  • Coordinates with title companies
  • Releases funds to complete replacement purchase
Without QI, exchange fails.
QI must be independent. Cannot be someone who has acted as your:
  • Agent (real estate agent, attorney, accountant)
  • Employee
  • Attorney or CPA (if represented you in last 2 years)
  • Family member
  • Related entity
Must engage QI before closing on relinquished property.
Consider:
  • Experience and volume of exchanges handled
  • Financial security (holding your funds)
  • Insurance and bonding
  • Segregated accounts (your funds not commingled)
  • References from real estate professionals
  • Fee structure
Fees typically range from $750 - $1,500 for standard forward exchange.
QI holds significant funds. If QI fails or commits fraud, you could lose exchange proceeds.Choose established, well-capitalized intermediaries. Verify insurance coverage and account segregation.

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Boot and Partial Exchanges

“Boot” is value received that doesn’t qualify for tax deferral.
Cash boot:
  • Taking cash from sale proceeds
  • Not reinvesting all proceeds
Mortgage boot:
  • New mortgage is less than old mortgage
  • Debt reduction creates taxable boot
Non-like-kind property:
  • Receiving personal property in exchange
Boot is taxable in year of exchange, up to amount of realized gain.
Example:
  • Sell property for $500,000 with $200,000 gain
  • Receive $50,000 cash boot
  • Pay tax on $50,000 (the lesser of boot or gain)
  • Remaining $150,000 gain deferred
  • Reinvest all net proceeds
  • Replace debt dollar for dollar (or add cash)
  • Purchase replacement of equal or greater value
  • Don’t receive any cash at closing
Sometimes investors accept some boot intentionally:
  • Need funds for other purposes
  • Difficult to find replacement of exact value
  • Tax on boot is acceptable for flexibility
Partial deferral is still valuable.

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Basis in Replacement Property

Replacement property basis = Relinquished property adjusted basis, plus any additional cash invested, plus boot recognized.
Example:
  • Relinquished property adjusted basis: $200,000
  • Additional cash invested: $50,000
  • Replacement property basis: $250,000
Lower basis means higher depreciation recapture and gain on eventual sale.
Begin depreciating replacement property based on allocated basis.If exchanging into property with improvements, allocate basis between land and building for depreciation purposes.

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When 1031 Makes Sense

  • Significant built-up equity and appreciation
  • Want to trade up to larger property
  • Repositioning portfolio (different market, property type)
  • Estate planning (basis step-up at death)
  • Exchanging management-intensive property for passive investment
  • Small gain that wouldn’t trigger significant tax
  • Need cash from sale for other purposes
  • No suitable replacement property available
  • Don’t want to continue real estate investment
  • Property has suspended passive losses that would be released on taxable sale
  • Installment sale: Spread gain over multiple years
  • Opportunity zone investment: Defer and potentially reduce gains
  • Charitable remainder trust: Defer gains with charitable component
  • Taxable sale: Pay tax and have full liquidity

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Common Mistakes

45-day and 180-day deadlines are absolute. No extensions for market conditions, financing delays, or title problems.Build buffer into timeline. Have backup properties identified.
Any access to sale proceeds disqualifies exchange. QI must be in place before closing.Don’t have proceeds sent to you “temporarily.”
Identification must be in writing, signed, and delivered to QI before deadline. Verbal identification doesn’t count.Include specific property addresses or legal descriptions.
1031 rules are complex. Mistakes are costly and usually irreversible.Engage QI, tax advisor, and real estate attorney before listing property.
1031 exchange rules are strict and mistakes cannot be corrected after deadlines pass. Engage qualified intermediary and tax professional before marketing property for sale.

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Planning Ahead

Before selling:
  • Consult tax advisor about exchange benefits
  • Engage qualified intermediary
  • Begin identifying potential replacement properties
  • Understand timeline constraints
  • Line up financing for replacement
After selling:
  • Meet 45-day identification deadline
  • Continue searching even after identification
  • Have backup financing ready
  • Close before 180-day deadline
  • File proper tax forms (Form 8824)

Next: Property Tax Appeals

Challenging assessments to reduce property taxes

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