How a 1031 exchange works for rental property investors

The short answer

A 1031 exchange lets you sell an investment property and buy another one without paying capital gains tax on the sale right away. The tax is deferred, not erased. To qualify, both properties must be real estate held for investment or business use, a qualified intermediary should hold the sale money, and you must identify the new property within 45 days and close within 180 days.

Key points

• Named for Section 1031 of the Internal Revenue Code.
• Works for investment and business real estate only, not your home and not property you bought to flip.
• Deadlines are 45 days to identify and 180 days to close, counted in calendar days from the day your sale closes.
• If you, your agent, or your property manager receives the sale money, the exchange can fail.
• To defer all of the tax, buy property of equal or greater value and reinvest all of the net cash.
• Report the exchange to the IRS on Form 8824.

What is a 1031 exchange?

A 1031 exchange is a trade of one investment property for another under Section 1031 of the Internal Revenue Code. When it is done correctly, the gain from the sale is not taxed in the year you sell. Your tax basis carries over into the new property, so the deferred gain stays with you until you sell without exchanging.

Most rental owners use what the IRS calls a delayed exchange: you sell first, then buy the replacement property within the deadlines.

What property qualifies?

Both the property you sell and the property you buy must be real property held for investment or for use in a trade or business. Since 2018, only real property qualifies; equipment, vehicles, and other personal property do not.

"Like-kind" is broad for real estate. A single-family rental can be exchanged for a duplex, a fourplex, land, or a commercial building. A few things do not qualify:

• Your personal residence.
• Property held primarily for resale, such as a fix-and-flip.
• Foreign real estate in exchange for U.S. real estate.
• Partnership interests, in most cases.

There is no fixed minimum holding period in the law. What matters is that you held the property, and intend to hold the replacement, for investment or business use. Ask your CPA how your situation reads.

What are the 45-day and 180-day deadlines?

Both deadlines start on the day the sale of your current property closes, and both count calendar days, including weekends and holidays.

• 45 days to identify. You must identify your replacement property in writing within 45 days.
• 180 days to close. You must close on the replacement property within 180 days, or by your tax return due date (including extensions), whichever comes first. If you sell late in the year, your CPA may need to file an extension to keep the full 180 days.

The deadlines run at the same time, not back to back. They are generally not extended, except for federally declared disasters and a few other situations the IRS defines.

How do I identify replacement property?

Identification must be in writing, signed by you, clear enough to pinpoint each property, and delivered to someone involved in the exchange, usually your qualified intermediary. Most investors use one of these rules:

• Three-property rule: identify up to three properties of any value.
• 200 percent rule: identify any number of properties whose combined value is no more than twice the value of what you sold.
• 95 percent exception: if you exceed both limits, you must actually acquire at least 95 percent of the total value you identified.

Do I need a qualified intermediary?

In practice, yes. A qualified intermediary is an independent company that holds your sale proceeds and handles the exchange paperwork. It is the IRS's "safe harbor" for delayed exchanges. If you, or someone acting as your agent, actually or effectively receives the money, the exchange can turn into a taxable sale.

Someone who has acted as your agent in the past two years, including your real estate broker, attorney, or employee, generally cannot serve as your qualified intermediary. That includes Silver Trust Property Management. The intermediary must be engaged before your sale closes.

How much do I need to reinvest to defer all of the tax?

As a rule of thumb, to defer all of the tax:

• Buy replacement property of equal or greater value than what you sold.
• Reinvest all of the net cash from the sale.
• Replace any mortgage you paid off, either with a new loan or with added cash.

Cash you keep, or debt that goes away without being replaced, is called "boot," and boot is taxable. The exact math accounts for closing costs, loans, and other items, so have your CPA run the numbers before you list.

Does the same person have to sell and buy?

Generally, yes. The same taxpayer that sells must buy. The names on the deeds do not have to match exactly: for example, an individual and that individual's single-member LLC are usually treated as the same taxpayer for federal tax purposes. A partnership and its partners are different taxpayers. Confirm your ownership structure with your CPA or attorney before you sell.

What about depreciation?

Depreciation recapture can usually be deferred along with the capital gain, but not automatically in every case. Depending on the property and how it was depreciated, part of the recapture can be taxed in the year of the exchange. Because your basis carries over, the replacement property does not get a fresh depreciation start. This is a CPA question every time.

Are there rules for buying from or selling to family?

Yes. Exchanges between related parties, such as close family members or entities you control, come with a two-year holding requirement and extra reporting. If either side disposes of its property within two years, the deferred gain can become taxable. A few exceptions exist.

How is a 1031 exchange reported?

A 1031 exchange is reported to the IRS on Form 8824, filed with your tax return for the year the exchange began, even when no gain is taxed.

Do I need a 1031 exchange inside an IRA or 401(k)?

Usually not. A sale inside a retirement account generally does not create current income tax, so a 1031 exchange is normally unnecessary. Financed properties inside an IRA can be an exception. See our guide to buying rental property with a self-directed IRA or Solo 401(k).

How Silver Trust Property Management helps

We are a licensed Texas real estate brokerage and property manager. We work alongside your qualified intermediary, CPA, and attorney; we do not replace them.

What we do

• Before you sell: a rental analysis on your current property and a plan for timing, so your search can start before the 45-day clock does.
• During the 45 days: help you find and compare rental candidates in San Antonio and the surrounding areas, with rent estimates, condition notes, and expected operating costs, so you can identify with confidence.
• Buying and selling: our sales division can represent you as a licensed Texas brokerage.
• At closing: management in place from day one, with the lease, deposit, and records handled on our systems.

What we never do

• Hold, receive, or direct your exchange funds.
• Act as your qualified intermediary.
• Give tax or legal advice, or tell you whether your exchange qualifies.

Checklist before you list your property

1. Talk to your CPA about the gain, the recapture, and whether an exchange makes sense.
2. Choose and engage a qualified intermediary before your sale closes.
3. Talk to your lender about financing the replacement property.
4. Start looking at replacement properties now, not after closing.
5. Put both deadlines on your calendar the day your sale closes.

Frequently asked questions

Can I exchange a single-family rental for a duplex or fourplex?

Yes. Both are real property held for investment, so they are like-kind to each other. The same is true for land and commercial property held for investment.

Does the replacement property have to be in Texas?

No. Any real property in the United States held for investment or business use can qualify. U.S. property cannot be exchanged for property outside the United States.

Can my real estate agent or property manager hold the sale money?

No. If you or your agent receives the money, the exchange can fail. An independent qualified intermediary should hold the funds, and someone who has acted as your agent in the past two years generally cannot serve in that role.

What happens if I miss the 45-day deadline?

The exchange generally fails and the sale is treated as a taxable sale. The deadline is counted in calendar days and is generally not extended, except for federally declared disasters and a few other situations the IRS defines.

Can I move into the replacement property?

A property you buy to live in does not qualify. The replacement must be held for investment or business use. Converting a property to personal use later has its own rules, so talk to your CPA before you change how you use it.

Sources

• Internal Revenue Code Section 1031 (Cornell Law School)
• Treasury Regulation 1.1031(k)-1: deferred exchanges (Cornell Law School)
• IRS Form 8824 instructions (IRS)
• IRS Publication 544, Sales and Other Dispositions of Assets (IRS)