1031 Exchanges
A 1031 exchange lets an owner of investment or business real estate sell it and buy other real estate without paying capital gains tax on the sale at the time of the sale. The gain is not forgiven; it is carried into the replacement property and deferred until that property is sold in a taxable transaction, or, if the owner dies still holding it, eliminated for income tax purposes by the basis adjustment at death. For investors who intend to stay in real estate, the exchange is the difference between reinvesting the full sale price and reinvesting what is left after federal and state tax.
An exchange requires advance coordination of the sale, replacement purchase, deadlines, and handling of proceeds. Milvidskiy Law Group P.C. structures the exchange within these transactions, coordinates the qualified intermediary, and aligns the ownership arrangement with the client’s estate plan.
Key Takeaways:
- Only real property held for investment or for use in a business qualifies, and the exchange must be in place before the sale closes. A seller who receives the proceeds, even briefly, has made a taxable sale.
- Two deadlines run from the day the sold property is transferred: replacement property must be identified in writing within 45 days, and it must be received within 180 days or by the due date of the return for that year, whichever is earlier. Neither is extended for weekends, holidays, or hardship.
- The exchange is a tax deferral, not a tax exemption. Gain carries into the replacement property, and the plan for the replacement property, including who holds it and what happens at death, is part of the exchange design.
How a Deferred Exchange Works
- The contract. The contract to sell the relinquished property includes a provision permitting the seller to assign its rights to a qualified intermediary and requiring the buyer to cooperate with the exchange.
- The intermediary. Before closing, the seller enters into an exchange agreement with a qualified intermediary, an independent party who is not the seller’s agent, attorney, accountant, or relative. At closing, the sale proceeds go to the intermediary, not to the seller.
- Identification. Within 45 days after the transfer of the relinquished property, the seller identifies the replacement property or properties in a signed writing delivered to the intermediary. The rules limit how many properties may be identified and at what aggregate value, with the limits depending on which identification rule is used.
- Acquisition. The intermediary uses the exchange funds to acquire the replacement property, which is transferred to the seller within 180 days after the transfer of the relinquished property or by the due date, including extensions, of the seller’s return for the year of the transfer, whichever is earlier.
- Reporting. The exchange is reported on Form 8824 with the return for the year of the transfer, and, where the exchange involves a related party, on the returns for the two following years as well.
What Qualifies
Since the 2017 tax law, only real property qualifies. Investment property may be exchanged for other investment property of any kind: an apartment building for a warehouse, land for a retail property, a rental condominium for a tenancy-in-common interest in an office building. The properties must be held for investment or for productive use in a trade or business on both sides of the exchange. A personal residence does not qualify, and property held primarily for sale, such as a house bought to renovate and flip, does not qualify either. Vacation property that is rented and used personally sits in a gray area, and the facts about rental and personal use decide it.
The taxpayer who sells must be the taxpayer who buys. An individual who sells cannot buy in a new LLC with a partner, and a partnership that sells cannot distribute the proceeds to its partners to buy separately, without breaking the exchange. Where the owners of a real estate holding company want to go separate ways, any restructuring has to be planned well before the sale.
Boot, Debt, and Partial Deferral
To defer all of the gain, the replacement property must cost at least as much as the relinquished property sold for, all of the exchange proceeds must be reinvested, and the debt on the replacement property must be at least as large as the debt paid off on the relinquished property, or the difference made up with cash. Any cash the seller receives, and any net reduction in debt, is taxable to the extent of the gain. A partially deferred exchange is still an exchange, and sometimes it is the right result, with the projected tax consequences evaluated before the contract is signed.
Reverse and Improvement Exchanges
When the replacement property must be bought before the relinquished property can be sold, a reverse exchange is possible. An exchange accommodation titleholder, under a safe harbor the IRS has published, takes title to the replacement property and holds it until the relinquished property is sold, within the same 180-day limit. The structure requires a written agreement with the titleholder, financing that the titleholder can hold, and careful attention to the requirement that the parked property not be one the taxpayer already owned within the prior 180 days. An improvement exchange uses a similar structure to have the titleholder build on or improve the replacement property with exchange funds before transferring it. Both cost more than a deferred exchange and are set up weeks before either closing.
Related-Party Exchanges and Other Planning Issues
An exchange with a related party, which includes family members and entities the taxpayer controls, is subject to a two-year holding requirement: if either party disposes of the exchanged property within two years, the deferred gain is generally recognized. Acquiring replacement property from a related party through an intermediary raises its own problems. Other recurring issues include the identification of properties that the taxpayer cannot in fact acquire, a delay in closing the replacement property past the deadline, proceeds used to pay costs that are not exchange expenses, and a relinquished property that was recently converted from a residence and has not been held for investment long enough to satisfy the requirement.
The Exchange and the Estate Plan
The deferred gain in exchanged property is eliminated for income tax purposes at the owner’s death, because the property receives a basis adjustment to fair market value. That makes the exchange a long-term estate planning tool as well as a tax deferral: an investor who exchanges through a career and holds the last property at death passes it to heirs who can sell without the accumulated gain. The strategy depends on holding the property in a way that qualifies for the basis adjustment, which a revocable trust or an entity owned by the investor does and a completed gift to an irrevocable trust does not. Our tax planning and estate planning attorneys design the ownership so that the exchange and the plan work together, while accounting for asset protection for the investor.
Planning and Coordinating Your Exchange
- Analysis of whether the property and the plan qualify, and of the gain, debt, and cash required for full deferral.
- Exchange cooperation and assignment provisions in the sale and purchase contracts.
- Selection and engagement of the qualified intermediary, and review of the exchange agreement and the intermediary’s security for the funds.
- Calendaring and monitoring of the 45-day and 180-day deadlines, and preparation of the identification notice.
- Structuring of reverse and improvement exchanges with an exchange accommodation titleholder.
- Restructuring of ownership before the sale where partners or family members intend to exchange separately.
- Coordination with your accountant on the reporting and with our estate planning attorneys on the ownership of the replacement property.
- Handling of the sale and purchase closings through our real estate and commercial real estate practices.
When an Exchange Is Not the Right Choice
An investor who wants to leave real estate, who needs the cash, or whose gain is small relative to the cost and constraints of an exchange may be better served by a taxable sale, an installment sale, or a sale timed to a year with offsetting losses. An owner with a property that has been depreciated to a low basis and who intends to hold to death may not need to exchange at all. And an owner who cannot find suitable replacement property within 45 days should consider whether completing an exchange still serves the investment goals. We compare these options before recommending the exchange.
Discuss Your Property Sale and Reinvestment
If you are planning to sell investment property, a consultation before signing the contract allows time to structure the exchange. Bring the closing statement from your purchase, your depreciation schedule, the loan documents, and any replacement properties you are considering. Our attorneys practice in New York, New Jersey, and Connecticut. Contact Milvidskiy Law Group P.C. to schedule a consultation.
This page is provided for general informational purposes only and does not constitute legal advice. Laws differ by state and change over time. For advice about your situation, consult a qualified attorney.
Frequently Asked Questions
What is a 1031 exchange?
A transaction under Section 1031 of the Internal Revenue Code in which real property held for investment or business use is exchanged for other real property of the same kind, so that the gain on the property given up is deferred rather than taxed at the time of the sale. The gain carries into the replacement property.
What are the deadlines?
Replacement property must be identified in writing within 45 days after the relinquished property is transferred, and it must be received within 180 days after that transfer or by the due date of the tax return for that year, including extensions, whichever is earlier. The deadlines are not extended for weekends or holidays.
Can I hold the sale proceeds myself until I find a replacement?
No. A seller who receives the proceeds, or has the right to receive them, has made a taxable sale. The proceeds must be held by a qualified intermediary under an exchange agreement signed before the sale closes.
Who can be a qualified intermediary?
An independent party who has not acted as the taxpayer’s agent, such as an attorney, accountant, real estate agent, or employee, within the prior two years, and who is not a related party. Intermediaries are not federally regulated in the way banks are, so the security of the exchange funds is reviewed before the intermediary is engaged.
What property qualifies?
Real property held for investment or for productive use in a trade or business. Since 2018, personal property no longer qualifies. A personal residence and property held primarily for sale do not qualify. Investment real estate of one kind may be exchanged for investment real estate of another kind.
What is boot?
Cash or other non-qualifying property received in the exchange, including a net reduction in mortgage debt. Boot is taxable to the extent of the gain. To defer all of the gain, the replacement property must be of equal or greater value, all exchange proceeds must be reinvested, and the debt must be replaced or made up with cash.
Can I buy the replacement property before I sell?
Yes, through a reverse exchange, in which an exchange accommodation titleholder holds the replacement property until the relinquished property is sold, within the same 180-day period. It costs more than a deferred exchange, requires financing the titleholder can hold, and is set up before the purchase closes.
Can I exchange with a family member?
Exchanges with related parties are permitted but subject to a two-year rule: if either party disposes of the exchanged property within two years, the deferred gain is generally recognized. Buying replacement property from a related party through an intermediary raises additional problems and is reviewed carefully.
Can partners in a selling entity go separate ways?
Only with planning done well before the sale. The taxpayer that sells must be the taxpayer that buys, so a partnership that distributes proceeds to its partners breaks the exchange. Restructuring the ownership in advance can allow partners to exchange separately, but the timing and the form of the restructuring matter.
What happens to the deferred gain when I die?
Property held at death generally receives a basis adjustment to fair market value, which eliminates the deferred gain for income tax purposes. That makes a series of exchanges ending with property held at death an estate planning strategy, provided the property is owned in a way that qualifies for the adjustment.
