1031 exchange basics: how to sell a rental and keep the tax bill waiting

What is a 1031 exchange?

A 1031 exchange lets you sell real property you hold for business or investment and buy other like kind real property without paying tax on the gain right away. The tax is deferred, not erased. Your old basis and the untaxed gain roll into the new property and wait for a future taxable sale.

The name comes from Section 1031 of the tax code. It works for rental houses, apartment buildings, commercial property and land held for investment. It does not work for your own home, and it does not work for property you hold primarily to sell, which is why house flippers are left out of the fun.

Vacation homes are a gray zone. A place only you use does not qualify, and the narrow IRS safe harbor for a mostly rented dwelling has specific rental and personal use tests.

What property qualifies for a 1031 exchange after 2017?

Since 2018, only real property qualifies. The Tax Cuts and Jobs Act removed equipment, vehicles and other personal property from 1031 treatment. Within real estate, like kind is broad: a rental house can be exchanged for a strip center or raw land, as long as both are held for business or investment and both are in the United States.

You do not have to trade a duplex for another duplex. In the eyes of the tax code, a single family rental and a warehouse are practically twins.

What are the 45 day and 180 day deadlines?

Both clocks start the day you transfer the property you are selling. You have 45 days to identify replacement property in writing, and you must receive the replacement property by the earlier of 180 days or the due date of your tax return for that year, including extensions. Miss either one and the exchange generally fails.

The two periods run at the same time, not back to back. The identification has to be a written document that you sign, delivered to the qualified intermediary or another party to the exchange who is not a disqualified person. It must describe the property clearly, such as a legal description or street address. You can generally identify up to three properties of any value, or any number of properties as long as their combined value does not exceed 200 percent of what you sold.

Here is the trap that catches people selling late in the year. If you sell in November, day 180 lands in May, but your return is due in April. Because the deadline is whichever comes first, filing on time would cut the exchange short. Extending your return keeps the full 180 days available.

What is a qualified intermediary and why do I need one?

A qualified intermediary holds the sale proceeds between selling the old property and buying the new one. If you actually or constructively receive the cash, even briefly, the exchange can turn into a plain taxable sale. The intermediary needs to be in place before the sale closes, not after the money lands in your account.

Not just anyone can play this role. The regulations treat people who have acted as your agent within the past two years, such as your attorney, accountant or real estate agent, as disqualified persons, with limited exceptions. A dedicated exchange company is the usual answer.

What is boot in a 1031 exchange?

Boot is anything you receive in the exchange that is not like kind real property. Leftover cash is boot, and so is debt relief that you do not replace with new debt or added cash. Boot is taxable up to the amount of your gain, so taking some money off the table usually means paying some tax.

To defer all of the gain, the usual approach is to buy replacement property of equal or greater value, reinvest all of the net proceeds and replace any mortgage that was paid off. Trading down in price or pocketing part of the proceeds is allowed, it just is not fully tax deferred.

What happens to depreciation recapture in a 1031 exchange?

Depreciation recapture does not disappear in a 1031 exchange. When the exchange fully defers the gain, the recapture that would have been taxed is carried over to the replacement property. Your new property also starts with a carryover basis, so future depreciation is smaller than it would be on a fresh purchase at the same price.

This is the part that makes a 1031 a deferral and not a gift. The depreciation you claimed on the old building still counts. If you later sell the replacement property in a regular taxable sale, the recapture rules can reach back to depreciation from both properties.

None of that makes the exchange a bad idea. It just means your records need to follow the basis from one property to the next.

How is a 1031 exchange reported on my tax return?

You report the exchange on Form 8824, filed with your tax return for the year you transferred the property you gave up. The form shows the properties, the key dates, any boot and the deferred gain. Exchanges with related parties carry extra reporting for the two years that follow and extra rules on resale.

With a family member or related business, either side selling within two years can generally unwind the deferral.

A 1031 is easiest when the plan comes before the listing. We cover exchanges as part of our real estate investor tax work and year round tax planning, for owners around Charlotte and virtually across the country.

Next step

Planning a sale? The plan should come before the listing, so the intermediary, the deadlines and the replacement property are lined up in advance. See our real estate investor tax services, or book a free intro call to talk through your situation.