The complete 1031 exchange guide

Section 1031 of the Internal Revenue Code allows an owner to defer recognition of gain when real property held for productive use in a trade or business or for investment is exchanged for other like-kind real property held for the same purposes. Since the 2017 tax law changes, Section 1031 applies to real property only — personal property exchanges were eliminated.

The word to focus on is defer. An exchange does not forgive tax. The deferred gain reduces the basis of the replacement property, so the tax generally comes due when that property is eventually sold in a taxable transaction. Owners sometimes exchange repeatedly over decades; what happens at death depends on estate tax rules and basis treatment at that time, which is a question for your CPA and estate attorney, not a real estate agent.

Like-kind is broader than most owners expect for real property. A single-family rental can generally be exchanged for an apartment building, retail space, industrial property, raw land held for investment, or a fractional interest structured appropriately. What matters is the nature of the holding — investment or business use — not the physical similarity of the asset.

Both the relinquished and replacement property must be held for investment or productive use in a trade or business. A primary residence does not qualify, and property held primarily for resale — a flip — generally does not either.

The taxpayer who sells must be the taxpayer who buys. If the relinquished property is held in an LLC, the same entity generally needs to acquire the replacement property. Partnership and co-ownership situations get complicated quickly and need to be planned well in advance.

A qualified intermediary must hold the proceeds. If you take actual or constructive receipt of the sale proceeds at any point, the exchange typically fails. This is the single most common way an otherwise valid exchange gets ruined, and it is entirely preventable by engaging a qualified intermediary before closing.

To fully defer, an owner generally needs to acquire replacement property of equal or greater value, reinvest all net equity, and replace any debt that was paid off — either with new debt or with additional cash. Falling short in value, equity or debt typically creates recognized gain.

Boot is anything received in the exchange that isn't like-kind property. Cash taken out at closing is cash boot. A reduction in mortgage debt that isn't offset is commonly described as mortgage boot. Either can cause part of the gain to be recognized in the year of the exchange.

A partial exchange is a legitimate choice. Some owners want liquidity and accept the tax on that portion. The important thing is to know the number in advance rather than discovering it at tax time. Model it with your CPA before the relinquished property closes, because after closing the structure is largely fixed.

Depreciation claimed or allowable reduces basis whether or not it was actually taken. On a taxable sale, a portion of gain attributable to depreciation may be subject to unrecaptured Section 1250 treatment at a different rate than long-term capital gain.

In an exchange, the replacement property's basis generally reflects the carried-over basis from the relinquished property adjusted for additional investment. Depreciation on the replacement property is typically calculated using a carryover component plus a component for any excess basis, following specific regulations. Your CPA sets this up; it is not something to guess at.

Starting too late. By far the most common failure is calling a qualified intermediary after the relinquished property is already in escrow with no exchange language, or worse, after it has closed.

Underestimating 45 days. Identification is a hard deadline in a market where suitable inventory may be limited. Owners who begin searching on day one are in a very different position than those who begin on day thirty.

Buying the wrong property to save tax. Deferral is not worth acquiring an asset you don't want, in a market you don't understand, with management you can't sustain.

Assuming rules apply that don't. Exchange requirements depend on facts. Entity structure, prior exchanges, related-party transactions, seller financing and improvement exchanges all change the analysis.