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1031 Exchange: How it Works

Written by Rocky Mengle, J.D. (Tax Attorney) • Reviewed by a TurboTax CPAUpdated for Tax Year 2023 • May 3, 2024 3:08 PM
OVERVIEW

Whether you're a first-time investor or a seasoned property owner, a 1031 exchange can impact your tax strategy significantly. With this type of transaction, real estate investors who sell property can defer capital gains taxes by reinvesting proceeds from the sold property into a new property.

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Key Takeaways

  • A 1031 exchange allows real estate investors to defer capital gains taxes by reinvesting the proceeds from the sale of a business or investment property into a new, "like-kind" property.
  • The replacement property in a 1031 exchange should be of equal or greater value to avoid paying taxes immediately. Otherwise, taxes may be due on the difference (which is known as "boot").
  • There are multiple types of 1031 exchanges, including deferred, simultaneous, reverse, and improvement exchanges, each with specific timelines and rules to follow for a successful exchange.
  • While a 1031 exchange defers taxes, your tax obligation isn't eliminated. Taxes are generally due if the replacement property is sold, unless the proceeds continue to be reinvested through additional 1031 exchanges.

What is a 1031 exchange?

Normally, when you sell investment property, you're required to pay capital gains tax on the profit. But with a 1031 tax-deferred exchange (also known as a “like-kind exchange”), you can delay payment of the tax on the sale of real property (your “original” property) if you use the proceeds from the sale to buy another property (“replacement” property) of “like kind.”

The IRS's definition of a “like-kind” property is broad. Basically, both the original and replacement properties must be used in a trade or business or held for investment. But beyond that, they can differ in grade, quality, and type. For example, you can exchange an apartment building for an office building, or undeveloped land for a warehouse.

The new property also doesn't have to be identical in value to the one you're selling. However, to delay all capital gains taxes, the replacement property should be of equal or greater value. If it's less, you might have to pay taxes on the difference.

How does a 1031 exchange work?

Completing a 1031 exchange requires careful planning and attention to detail. Since the process can be complicated, it’s wise to consult a tax professional. But for a general understanding of how a 1031 exchange works, here’s a brief description of the steps involved in a typical like-kind exchange.

1. Choose the property you want to sell

Identifying the property you want to sell is a good place to start. This should be an investment property you own that would trigger a capital gain tax if sold without going through a 1031 exchange.

2. Choose the property you want to buy

When selecting a replacement property for a 1031 exchange, you should consider the property’s location. For example, if the replacement property is in a different state, you’ll want to review the tax rules in both the selling and buying locations to avoid unexpected state tax consequences. Also note that property in the U.S. and property outside the U.S. are not considered “like-kind” property.

3. Select a qualified intermediary

A qualified intermediary, also known as an exchange facilitator, plays an important role in a 1031 exchange. The qualified intermediary holds the proceeds from the sale of your original property and ensures they're used to purchase the new property. Make sure you choose an experienced and reliable qualified intermediary, since they'll be handling critical aspects of the exchange. The qualified intermediary can’t be a relative or anyone that you’ve had a formal relationship with (e.g., as an agent, broker, accountant, attorney, or employee) within a two-year period before the exchange. 

4. Decide how much of the sale proceeds to use to buy the new property

The goal in a 1031 exchange is often to defer all capital gains taxes. To achieve this, you should use all the proceeds from the sale of your original property to purchase the replacement property. If you only use part of the proceeds, the remaining funds are taxed right away.

What are the different types of 1031 exchanges?

There are a few different types of 1031 exchanges. Each one has its own unique considerations, benefits, and requirements. Which one is best for you depends on your investment needs and timeline.

Deferred 1031 exchange

A deferred exchange is the most common type of 1031 exchange (it’s sometimes called a “Starker” or delayed exchange). With this type of exchange, you sell the original property before buying the replacement property. However, the transaction must be an exchange of property for property, not a transfer of property for money used to buy the replacement property.

To complete a deferred 1031 exchange, you must identify the replacement property within 45 days after selling the original property. You then have an additional 135 days (for a total of 180 days from the original sale date) to actually purchase the replacement property.

Simultaneous 1031 exchange

A simultaneous exchange happens when the sale of the original property and purchase of the replacement property happen at the same time. It's the most straightforward form of a 1031 exchange, but coordinating both the sale and purchase to happen on the same day can be difficult.

Reverse 1031 exchange

A reverse exchange involves purchasing the replacement property before selling the original one. In this case, a qualified intermediary holds the replacement property once it’s purchased. From that point, you have 45 days to identify the property you want to sell, which must be sold within 180 days of the replacement property's purchase.

Improvement 1031 exchange

Also known as a construction or build-to-suit exchange, an improvement exchange lets you use proceeds from the sale of the original property to improve the replacement property. This might be a good option if you can’t find a like-kind property that meets your current needs. However, you must complete the improvements within 180 days from the sale of the original property.

TurboTax Tip:

A 1031 exchange can also delay payment of the net investment income tax. This additional tax only kicks in if you make a certain amount of money, and it adds an extra 3.8% tax on investment income (e,g., interest, dividend income, rental income, etc.) and profits from selling investment property like real estate.

Special rules for 1031 exchanges

There can be many twists and turns involved with a 1031 exchange. As a result, there are several special rules to cover certain transactions and situations. Here are a few of the more common special rules you should be aware of before entering into a like-kind exchange.

Depreciable property

Generally, when you sell depreciable real property, previously claimed depreciation deductions are “recaptured” and taxed (i.e., you have to pay back the deductions). But with a 1031 exchange, you can defer the recapture tax (along with the capital gains tax) by transferring the cost basis from the original property to the replacement property. In essence, you’ll calculate depreciation on the replacement property based on the original property's schedule.

However, to fully avoid depreciation recapture following a 1031 exchange, the replacement property must also be subject to depreciation (e.g., it can’t be undeveloped land). It must also be of equal or greater value, and you need to continue using it in a trade or business or for investment purposes.

Exchanges between related parties

Special rules apply to 1031 exchanges between family members to make sure these property swaps aren’t simply arranged to avoid taxes. If you exchange properties with a family member, you both need to hold the properties involved for at least two years after the trade. Otherwise, any tax deferral will be canceled as of the date one of the exchanged properties is disposed of by either you or your relative.

There are a few exceptions to the two-year rule for 1031 exchanges between relatives. Taxes can still be deferred if one of the properties is sold or otherwise disposed of by either party if any of the following applies:

  • The property is involuntarily disposed of (e.g., through eminent domain or after a natural disaster) within the two-year period
  • One of the related parties involved in the exchange dies within the two-year period
  • The IRS is satisfied that neither the 1031 exchange nor the subsequent sale or disposition of one of the properties was done to avoid taxes

Exchange of a home or other dwelling unit (including a second home)

Since both properties involved in a 1031 exchange must be held for use in a trade or business or for investment, a primary residence (i.e., your main home) generally isn’t considered “like-kind” property. However, special IRS rules exist that basically permit you to treat houses and other dwelling units as if they’re held for business or investment purposes. These rules (1) allow a vacation home to be exchanged for a replacement property (including a different second home), and/or (2) let you eventually move into a replacement property.

For a vacation home or other dwelling unit to qualify as an original property in a 1031 exchange, you must have own the property for at least two years before the exchange, and for each of those years both of the following requirements must be satisfied:

  • You rented the property for at least 14 days
  • You didn’t stay in the property for more than 14 days or 10% of the number of days it was rented, whichever is greater

The rules are similar if you want to move into a replacement property and use it as your primary residence. In that case, you must own the replacement property for at least two years before moving in, and for each of those years both of the following must be true:

  • You rent the property for at least 14 days
  • You don’t stay in the property for more than 14 days or 10% of the number of days it’s rented, whichever is greater

When are taxes paid following a 1031 exchange?

It's important to remember that a 1031 exchange only delays taxes; it doesn’t eliminate them. A tax bill eventually comes due if you sell the replacement property and don’t reinvest the proceeds into a new property with another 1031 exchange. The original property’s basis generally transfers to the replacement property for purposes of calculating the tax due.

As noted earlier, failing to invest all the proceeds from the sale of your original property in replacement property can also trigger taxes on the unused proceeds.

Other situations can lead to a tax bill, too. For instance, tax may be due if you convert the replacement property to your primary residence without following the rules outlined above or otherwise fail to use the property for investment or business purposes.

Estate planning

If you inherit replacement property after the owner dies, the property’s basis is “stepped up” (i.e., increased) to the property’s fair market value at the time of the owner's death. Since taxable gain following the sale of property is generally determined by subtracting the property’s basis from the sales price, you could theoretically sell the inherited property right away for fair market value without having any taxable gain, since the property’s basis would be equal to the sales price. This can reduce or even eliminate the deferred capital gains tax that was postponed through a 1031 exchange.

As a result, incorporating replacement properties into your estate plan is a common strategy for real estate investors. But it’s important to consult with an estate planning professional to make sure all the legal boxes are checked and that a 1031 exchange aligns with your overall estate planning goals.

Reporting a 1031 exchange to the IRS

After completing a 1031 exchange, you must report the transaction to the IRS using Form 8824 to maintain the transaction’s tax-deferred status. You must file the form with your annual income tax return for the year in which the exchange was completed.

Form 8824 asks for details about the properties exchanged, dates of the relevant transactions, fair market values for the related properties, any cash received or paid, realized gain or (loss), related parties, and more. Keep all related documents (e,g., contracts, closing statements, and intermediary arrangements), since these will be necessary to complete Form 8824 accurately.

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The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.

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  • Audit Support Guarantee – Individual Returns: If you receive an audit letter from the IRS or State Department of Revenue based on your 2023 TurboTax individual tax return, we will provide one-on-one question-and-answer support with a tax professional, if requested through our Audit Report Center, for audited individual returns filed with TurboTax Desktop for the current 2023 tax year and, for individual, non-business returns, for the past two tax years (2021, 2022). Audit support is informational only. We will not represent you before the IRS or state tax authority or provide legal advice. If we are not able to connect you to one of our tax professionals, we will refund the applicable TurboTax federal and/or state license purchase price you paid. This guarantee is good for the lifetime of your personal, individual tax return, which Intuit defines as seven years from the date you filed it with TurboTax Desktop. Excludes TurboTax Desktop Business returns. Additional terms and limitations apply. See License Agreement for details.

  • Satisfaction Guarantee/ 60-Day Money Back Guarantee: If you're not completely satisfied with TurboTax Desktop, go to refundrequest.intuit.com within 60 days of purchase and follow the process listed to submit a refund request. You must return this product using your license code or order number and dated receipt.

TurboTax Desktop Business Returns:

  • 100% Accurate Calculations Guarantee – Business Returns: If you pay an IRS or state penalty or interest because of a TurboTax calculation error, we’ll pay you the penalty and interest. Excludes payment plans. You are responsible for paying any additional tax liability you may owe. Additional terms and limitations apply. See License Agreement for details.

  • Maximum Tax Savings Guarantee – Business Returns: If you get a smaller tax due (or larger business tax refund) from another tax preparation method using the same data, TurboTax will refund the applicable TurboTax Business Desktop license purchase price you paid. Additional terms and limitations apply. See License Agreement for details.

  • Satisfaction Guarantee/ 60-Day Money Back Guarantee: If you're not completely satisfied with TurboTax Desktop, go to refundrequest.intuit.com within 60 days of purchase and follow the process listed to submit a refund request. You must return this product using your license code or order number and dated receipt.

TURBOTAX DESKTOP

  • Installation Requirements: Product download, installation and activation requires an Intuit Account and internet connection. Product limited to one account per license code. You must accept the TurboTax License Agreement to use this product. Not for use by paid preparers.

  • TurboTax Desktop Products: Price includes tax preparation and printing of federal tax returns and free federal e-file of up to 5 federal tax returns. Additional fees may apply for e-filing state returns. E-file fees may not apply in certain states, check here for details. Savings and price comparison based on anticipated price increase. Software updates and optional online features require internet connectivity.

  • Fastest Refund Possible: Fastest federal tax refund with e-file and direct deposit; tax refund time frames will vary. The IRS issues more than 9 out of 10 refunds in less than 21 days.

  • Average Refund Amount: Sum of $3140 is the average refund American taxpayers received based upon IRS data date ending 02/17/23 and may not reflect actual refund amount received.

  • TurboTax Product Support: Customer service and product support hours and options vary by time of year.

  • #1 Best Selling Tax Software: Based on aggregated sales data for all tax year 2022 TurboTax products.

  • Deduct From Your Federal or State Refund (if applicable): A $40 Refund Processing Service fee may apply to this payment method. Prices are subject to change without notice.

  • Data Import: Imports financial data from participating companies; Requires Intuit Account. Quicken and QuickBooks import not available with TurboTax installed on a Mac. Imports from Quicken (2021 and higher) and QuickBooks Desktop (2021 and higher); both Windows only. Quicken import not available for TurboTax Desktop Business. Quicken products provided by Quicken Inc., Quicken import subject to change.

  • Audit Defense: Audit Defense is a third-party add-on service provided, for a fee, by TaxResources, Inc., dba Tax Audit. See Membership Agreements at https://turbotax.intuit.com/corp/softwarelicense/ for service terms and conditions.

All features, services, support, prices, offers, terms and conditions are subject to change without notice.

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