What Is a 1031 Exchange? Know the Rules

How savvy investors use 1031s to defer capital gains and build wealth

Reviewed by David Kindness
Fact checked by Marcus Reeves

A 1031 exchange is a swap of one real estate investment property for another that allows capital gains taxes to be deferred. The term—which gets its name from Section 1031 of the Internal Revenue Code (IRC)—is often used by real estate agents, title companies, investors, and more. Some people even insist on making it into a verb, as in, “Let’s 1031 that building for another.”

IRC Section 1031 has many moving parts that real estate investors must understand before attempting its use. An exchange can only be made with like-kind properties, and Internal Revenue Service (IRS) rules limit its use with vacation properties. There are also tax implications and time frames that may be problematic.

If you are considering a 1031 exchange—or are just curious—here is what you should know about the rules.

Key Takeaways

• A 1031 exchange allows investors to defer capital gains tax on the sale of one investment property by reinvesting the proceeds into another like-kind property.
• The like-kind exchange must involve real estate properties, not personal property (except in specific cases, such as real estate businesses).
• The exchanged properties must be in the United States to qualify.
• There are strict time limits: The replacement property must be identified within 45 days, and the exchange must be completed within 180 days.
• Cash or mortgage differences, called “boot,” can trigger tax liabilities.

What Is Section 1031?

In essence, a 1031 exchange (also called a like-kind exchange or Starker exchange) allows real estate investors to trade on investment property for another of similar type, avoiding the recognition of capital gains at the time of the swap. Most swaps are taxable as sales, although if yours meets the requirements of 1031, you’ll either have no tax or limited tax due at the time of the exchange. This lets you roll over your profits from one investment property to the next, thereby deferring taxes until you eventually sell the property for cash.

There’s no limit on how frequently you can do a 1031 exchange. If it works out as planned, you’ll pay only one tax at a long-term capital gains rate (currently 15% or 20%, depending on income—and 0% for some lower-income taxpayers, as of 2024).

For example, you might exchange an apartment building for raw land or a commercial property. As long as both properties are used for business or investment purposes and are located within the U.S., they qualify for a 1031 exchange. The rules are surprisingly liberal. You can even exchange one business for another, but there are traps for the unwary.

The 1031 provision is for investment and business property, though the rules can apply to a former principal residence under certain conditions. You can also use 1031 for swapping vacation homes—more on that later—but this loophole is much narrower than it used to be.

Important

Both properties must be located in the United States to qualify for a 1031 exchange.

Special Rules for Depreciable Property

Special rules apply when a depreciable property is exchanged. It can trigger a profit known as depreciation recapture, which is taxed as ordinary income. Generally, if you swap one building for another building, you can avoid this recapture. However, if you exchange improved land with a building for unimproved land without a building, then the depreciation that you’ve previously claimed on the building will be recaptured as ordinary income.

Changes to 1031 Rules

Before the passage of the Tax Cuts and Jobs Act (TCJA) in December 2017, some exchanges of personal property—such as franchise licenses, aircraft, and equipment—qualified for a 1031 exchange. Now only real property (or real estate) as defined in Section 1031 qualifies. It’s worth noting, however, that the TCJA full expensing allowance for certain tangible personal property may help to make up for this change to tax law.

Important

Exchanges of corporate stock or partnership interests never did qualify—and still don’t—but interests as a tenant in common (TIC) in real estate still do.

1031 Exchange Timelines and Rules

Classically, an exchange involves a simple swap of one property for another between two people. However, the odds of finding someone with the exact property you want who wants your property are slim. For that reason, most exchanges are delayed, three-party, or Starker exchanges (named for the first tax case that allowed them).

In a delayed exchange, you need a qualified intermediary (middleman) who holds the cash after you sell your property and uses it to buy the replacement property for you. This three-party exchange is treated as a swap.

There are two key timing rules that you must observe in a delayed exchange.

45-Day Rule

The first timing rule relates to the designation of a replacement property. Once your property is sold, the intermediary will receive the cash. You can’t accept the cash or it will spoil the 1031 treatment. Also, within 45 days of the sale of your property, you must designate the replacement property in writing to the intermediary, specifying the property that you want to acquire.

The IRS says you can designate three properties as long as you eventually close on one of them. You can even designate more than three if they fall within certain valuation tests.

180-Day Rule

The second timing rule in a delayed exchange relates to closing. You must close on the new property within 180 days of the sale of the old property.

Warning

The two time periods run concurrently, which means that you start counting when the sale of your property closes. For example, if you designate a replacement property exactly 45 days later, you’ll have just 135 days left to close on it.

Reverse Exchange

It’s also possible to buy the replacement property before selling the old one and still qualify for a 1031 exchange. In this case, the same 45- and 180-day time windows apply.

To qualify, you must transfer the new property to an exchange accommodation titleholder, identify a property for exchange within 45 days, and complete the transaction within 180 days after the replacement property was bought.

1031 Exchange Tax Implications: Cash and Debt

The proceeds from a 1031 exchange must be handled carefully. If there’s any cash left over after the exchange (known as “boot“), it will be taxable as a capital gain. Similarly, if there’s a discrepancy in debt—say, your old property had a larger mortgage than the new property—the difference in liabilities is treated as boot and taxed accordingly.

For example, if you sell a property with a $1 million mortgage and buy a new one with a $900,000 mortgage, the $100,000 difference would be taxed as income.

One of the main ways that people get into trouble with these transactions is failing to consider loans. You must consider mortgage loans or other debt on the property you relinquish and any debt on the replacement property. If you don’t receive cash back but your liability goes down, then that also will be treated as income to you, just like cash.

1031 Exchanges for Vacation Homes

You might have heard tales of taxpayers who used the 1031 provision to swap one vacation home for another, perhaps even for a house where they want to retire, and Section 1031 delayed any recognition of gain. Later, they moved into the new property, made it their principal residence, and eventually planned to use the $500,000 capital gain exclusion. This allows you to sell your principal residence and, combined with your spouse, shield $500,000 in capital gain as long as you’ve lived there for two years out of the past five.

In 2004, Congress tightened that loophole. However, taxpayers can still turn vacation homes into rental properties and do 1031 exchanges. For example, you stop using your beach house, rent it out for six months or a year, and then exchange it for another property. If you get a tenant and conduct yourself in a businesslike way, then you’ve probably converted the house to an investment property, which should make your 1031 exchange all right.

Per the IRS, offering the vacation property for rent without having tenants would disqualify the property for a 1031 exchange.

Moving Into a 1031 Swap Residence

If you want to use the property for which you swapped as your new second or even principal home, you can’t move in right away. In 2008, the IRS set forth a safe harbor rule, under which it said it would not challenge whether a replacement dwelling qualified as an investment property for purposes of Section 1031. To meet that safe harbor in each of the two 12-month periods immediately after the exchange:

• You must rent the dwelling unit to another person for a fair rental for 14 days or more.
• Your personal use of the dwelling unit cannot exceed 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.

Moreover, after successfully swapping one vacation or investment property for another, you can’t immediately convert the new property to your principal home and take advantage of the $500,000 exclusion.

Before the law was changed in 2004, an investor might transfer one rental property in a 1031 exchange for another rental property, rent out the new rental property for a period, move into the property for a few years, and then sell it, taking advantage of exclusion of gain from the sale of a principal residence.

Now, if you acquire property in a 1031 exchange and later attempt to sell that property as your principal residence, the exclusion will not apply during the five-year period beginning with the date when the property was acquired in the 1031 like-kind exchange. In other words, you’ll have to wait a lot longer to use the principal residence capital gains tax break.

1031s for Estate Planning

One of the most significant benefits of 1031 exchanges is their potential for estate planning. When you die, your heirs inherit your property at its stepped-up market value, and they won’t have to pay the capital gains tax you deferred. Essentially, a 1031 exchange can pass the tax liability onto the heirs.

How to Report 1031 Exchanges to the IRS

You must notify the IRS of the 1031 exchange by compiling and submitting Form 8824 with your tax return in the year when the exchange occurred.

The form will require you to provide descriptions of the properties exchanged, the dates when they were identified and transferred, any relationship that you may have with the other parties with whom you exchanged properties, and the value of the like-kind properties. You’re also required to disclose the adjusted basis of the property given up and any liabilities that you assumed or relinquished.

It’s important to complete the form correctly and without error. If the IRS believes that you haven’t played by the rules, you could be hit with a big tax bill and penalties.

Form 8824 is available on the IRS website.

Can You Do a 1031 Exchange on a Principal Residence?

A principal residence usually does not qualify for 1031 treatment because you live in that home and do not hold it for investment purposes. However, if you rented it out for a reasonable time period and refrained from living there, then it becomes an investment property, which might make it eligible.

Can You Do a 1031 Exchange on a Second Home?

1031 exchanges apply to real property held for investment purposes. Therefore, a regular vacation home won’t qualify for 1031 treatment unless it is rented out and generates an income.

How Do I Change Ownership of Replacement Property After a 1031 Exchange?

It is advisable to hold the property for several years after an exchange before changing ownership. If you sell too soon, the IRS may disqualify the exchange.

What Is an Example of a 1031 Exchange?

Kim owns an apartment building that’s currently worth $2 million, double what she paid for it seven years ago. She’s content until her real estate broker tells her about a larger condominium located in an area fetching higher rents that’s on the market for $2.5 million.

By using the 1031 exchange, Kim could, in theory, sell her apartment building and use the proceeds to help pay for the bigger replacement property without having to worry about the tax liability straightaway. By deferring capital gains and depreciation recapture taxes, she is effectively left with extra money to invest in the new property.

What Is 1031 Exchange Depreciation Recapture?

Depreciation enables real estate investors to pay lower taxes by deducting the costs of wear and tear on a property over its useful life.

Normally, when that property is eventually sold, the IRS will want to recapture some of those deductions and factor them into the total taxable income. A 1031 exchange can help to delay that event by essentially rolling over the cost basis from the old property to the new one that is replacing it. In other words, your depreciation calculations continue as if you still owned the old property.

The Bottom Line

Savvy real estate investors can use a 1031 exchange as a tax-deferred strategy to build wealth. However, the many complex moving parts require understanding the rules and enlisting professional help—even for seasoned investors.