Short answer
A 1031 exchange lets you sell investment or business real estate and defer the capital gains tax by buying other real estate. To qualify, you must follow a short list of rules: both properties must be U.S. real property held for investment or business, the same taxpayer must sell and buy, a qualified intermediary must hold the money, you must identify replacement property within 45 days and close within 180 days, and you must reinvest all the proceeds and replace the debt to defer all of the tax. The rules are in IRC §1031 and its regulations.
| # | Rule | Where it comes from |
|---|---|---|
| 1 | Real property only | IRC §1031(a)(1), as amended for exchanges after 2017 |
| 2 | Held for investment or business, not for resale | IRC §1031(a)(1)-(2) |
| 3 | Like-kind: U.S. real estate for U.S. real estate | Treas. Reg. §1.1031(a)-1; IRC §1031(h) |
| 4 | Same taxpayer sells and buys | Long-standing IRS position |
| 5 | No access to the cash: use a qualified intermediary | Treas. Reg. §1.1031(k)-1(g) |
| 6 | Identify within 45 days | IRC §1031(a)(3)(A) |
| 7 | Close within 180 days or by the tax return due date | IRC §1031(a)(3)(B) |
| 8 | Reinvest all proceeds and replace the debt to defer all tax | IRC §1031(b); Treas. Reg. §1.1031(d)-2 |
| 9 | Related parties: 2-year hold | IRC §1031(f) |
| 10 | Report it on Form 8824 | Instructions for Form 8824 |
On this page
- 01Rules 1 to 3: what property qualifies
- 02Rules 4 to 7: how the exchange must be done
- 03Rule 8: reinvest everything to defer everything
- 04Rule 9 and the "2-year rule"
- 05The 5-year rule
- 06Rule 10: report it
- 07Example: what following the rules is worth
- 08Quick self-check before you sell
- 09Downsides to weigh
- 10Frequently asked questions
- 11Sources
Rules 1 to 3: what property qualifies
1. Real property only
Since the Tax Cuts and Jobs Act, Section 1031 applies only to real property. Exchanges of equipment, vehicles, artwork, livestock or other personal property completed after 2017 do not qualify. Real property includes land, buildings and other inherently permanent structures, and some rights in land such as easements and long-term leaseholds (Treas. Reg. §1.1031(a)-3). Furniture or appliances worth no more than 15% of a property's value can transfer with it without breaking the exchange, but they are not deferred.
2. Held for investment or business use
Both the property you sell and the one you buy must be held for productive use in a trade or business or for investment. That excludes your main home, a vacation home you only use yourself, and property held primarily for sale, such as a flip or lots a developer builds to sell. The statute sets no minimum number of days; intent and use decide it. See how long you have to own a property before a 1031 exchange.
3. Like-kind means real estate for real estate
"Like-kind" refers to the nature of the property, not its grade or quality (Treas. Reg. §1.1031(a)-1(b)). Any U.S. investment real estate is like-kind to any other: a rental house for an apartment building, land for a warehouse, a commercial building for residential rentals, or a building for an interest in a Delaware statutory trust. U.S. and foreign real estate are not like-kind (§1031(h)), and stocks, bonds and REIT shares never qualify.
Rules 4 to 7: how the exchange must be done
4. The same taxpayer sells and buys
The name on the title of the replacement property must match the taxpayer that sold. A single-member LLC that is disregarded for tax counts as its owner, so you can sell personally and buy in your single-member LLC. A partnership that sells must also buy; partners cannot go separate ways without planning such as a drop and swap.
5. You cannot receive the money
If you have actual or constructive receipt of the sale proceeds, even for a day, the exchange is over. The standard protection is a qualified intermediary under the safe harbor in Treas. Reg. §1.1031(k)-1(g). The exchange agreement must be signed and the contract assigned before the sale closes. Your own attorney, agent or accountant who has worked for you in the last two years cannot act as your QI.
6. Identify within 45 days
By midnight of day 45 after the sale, you must identify the replacement property in a signed, written notice: up to three properties, or more within the 200% or 95% limits. See the 45-day rule.
7. Close within 180 days
You must receive the replacement property by day 180 or the due date of your tax return for the year of the sale (with extensions), whichever comes first. Weekends and holidays count, and only federal disaster relief extends it. See the 1031 exchange timeline.
Rule 8: reinvest everything to defer everything
There is no rule that the replacement property must cost more. But any cash you keep and any debt you are relieved of without replacing it is boot, and boot is taxed up to the amount of your gain (§1031(b)). To defer all of the tax:
- buy property that costs at least as much as the net sale price, and
- reinvest all of the net cash proceeds, and
- take on at least as much debt as you paid off, or add your own cash to make up the difference (Treas. Reg. §1.1031(d)-2).
Not reaching these targets does not cancel the exchange. It makes part of the gain taxable. Work it out with the partial 1031 boot calculator, and see does the replacement property have to be equal or greater value?
Rule 9 and the "2-year rule"
"The 2-year rule" is used for two different things:
- Related parties. If you exchange with a relative or a company you control, both of you must keep the properties for two years, or the deferred gain becomes taxable (§1031(f)). See related party rules.
- Vacation homes and holding periods. The IRS safe harbor for dwelling units in Rev. Proc. 2008-16 looks at 24 months of rental history before and after the exchange. Many advisers also use two years as a practical minimum hold to show investment intent, although the law sets no fixed period.
More: what is the 2-year rule for a 1031 exchange?
The 5-year rule
If you move into a property you acquired in a 1031 exchange and later sell it as your home, you cannot use the home-sale exclusion (up to $250,000, or $500,000 for married couples) unless you have owned it for at least five years since the exchange (IRC §121(d)(10)). Even then, gain from depreciation and from the years it was a rental may still be taxable. See 1031 exchanges and your primary residence.
Rule 10: report it
You report the exchange on Form 8824 with your return for the year you sold. Your basis carries over: the deferred gain reduces the basis of the new property, so it is taxed later if you sell for cash. See how to report a 1031 exchange and the Form 8824 worksheet.
Example: what following the rules is worth
A married couple sells a rental for $800,000 that they bought for $500,000 and depreciated by $100,000. Their adjusted basis is $400,000 and the gain is $400,000. If they sold without an exchange and were in the 15% capital gains bracket, the federal tax would be about $25,000 on the $100,000 of depreciation (25%) plus $45,000 on the other $300,000 (15%): roughly $70,000, plus the 3.8% net investment income tax if their income is above $250,000, plus state tax. In a full exchange, they reinvest the whole amount and pay none of it now. Compare your own numbers with the capital gains vs 1031 exchange comparison.
Quick self-check before you sell
- Is the property I am selling a rental, business or investment property, not my home or a flip?
- Will I buy U.S. real estate that I will also hold for investment or business?
- Will the buyer of the new property be the same taxpayer that is selling?
- Is a qualified intermediary engaged and the exchange agreement signed before closing?
- Do I know my day-45 and day-180 dates, and do I need a tax return extension?
- Will I reinvest all the cash and replace the debt?
- Is the buyer or seller a relative or my own company?
If any answer is unclear, check whether your property qualifies before you list it.
Downsides to weigh
The tax is deferred, not forgiven, unless you hold until death, when heirs generally receive a stepped-up basis (IRC §1014). The new property inherits a lower basis, so depreciation deductions are smaller. The deadlines can push you into a rushed purchase, and you cannot take cash out without paying tax on it. If those costs outweigh the deferral, see alternatives to a 1031 exchange.
Frequently asked questions
What is the 2-year rule for a 1031 exchange?
It usually means the related-party rule: if you exchange with a relative or an entity you control, both sides must hold the properties for two years or the deferred gain becomes taxable. People also use it for the 24-month rental test for vacation homes in Rev. Proc. 2008-16.
What is the 5-year rule for a 1031 exchange?
If you convert a property acquired in a 1031 exchange into your home, you must own it at least five years after the exchange before you can use the $250,000 or $500,000 home-sale exclusion.
What is a poor man's 1031 exchange?
It is an informal name for the home-sale exclusion under IRC §121, which lets you exclude up to $250,000 of gain ($500,000 for married couples) on a home you owned and lived in for two of the last five years. It is not a 1031 exchange.
Do I have to buy a more expensive property?
Not to qualify. But to defer all of the tax, you must reinvest all the net proceeds and replace the debt. Any shortfall is taxable boot.
Sources
- 26 U.S.C. §1031 (the statute)
- Treas. Reg. §1.1031(a)-1 (like-kind and investment use)
- Treas. Reg. §1.1031(a)-3 (definition of real property)
- Treas. Reg. §1.1031(k)-1 (deferred exchanges and qualified intermediaries)
- Treas. Reg. §1.1031(d)-2 (assumption of liabilities)
- Rev. Proc. 2008-16 (dwelling unit safe harbor)
- 26 U.S.C. §121 (home sale exclusion and the 5-year rule)
- 26 U.S.C. §1014 (stepped-up basis at death)
- Instructions for Form 8824 (reporting)
This article is general information, not tax or legal advice. Talk to your CPA or tax attorney about your situation.
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