What is the IRS 1031 Exchange Tax Deferment Provision?

A 1031 Exchange is a tax deferment provision in the US tax code (Internal Revenue Code Section 1031) that allows an investor to defer paying capital gains taxes on the sale of an investment property if they use the proceeds to purchase a "like-kind" replacement property. This provision allows investors to reinvest the proceeds from the sale of an investment property into another investment property without having to pay capital gains taxes on the sale, thus allowing the investor to defer paying taxes on the gain until they sell the replacement property.

Who qualifies for the 1031 Exchange Tax Deferment Provision?

The 1031 Exchange tax deferment provision is available to individuals, trusts, partnerships, limited liability companies (LLCs), and corporations who own investment or business properties that are classified as like-kind to the replacement property under Internal Revenue Code (IRC) section 1031. Primary residences, vacation homes, or rental properties used for personal use do not qualify for a 1031 Exchange.

What does "like-kind" mean in a 1031 exchange?

In the context of a 1031 Exchange, the IRS defines like-kind properties as those that are of the same nature or character, even if they differ in grade or quality. For example, a single-family rental property can be exchanged for a multi-unit rental property, or raw land can be exchanged for improved land.

It's important to note that like-kind properties are limited to real estate located in the United States, and personal property, such as artwork, collectibles, and equipment, do not qualify for a 1031 Exchange.

What are the steps and timeline requirements of the 1031 Exchange provision?

The steps and timelines of the 1031 Exchange tax deferment provision are as follows:

#1. Identification of replacement property: Within 45 days of the sale of the relinquished property, the taxpayer must identify in writing one or more potential replacement properties that they plan to purchase as part of the 1031 Exchange.


#2. Closing of the relinquished property sale: The taxpayer must close the sale of the relinquished property and transfer the proceeds to the qualified intermediary.


#3. Acquisition of replacement property: The taxpayer must use the proceeds from the sale of the relinquished property to purchase the replacement property within 180 days of the sale of the relinquished property.


#4. Filing of Form 8824: The taxpayer must file Form 8824 with the IRS within 45 days of the closing of the replacement property to notify the IRS of the 1031 Exchange and defer the payment of taxes.


So, in summary, under the 1031 Exchange tax deferment provision you have 45 days from the date of the sale of the relinquished property to identify potential replacement properties, which must be identified in writing, signed by the taxpayer and delivered to a person involved in the exchange, such as the qualified intermediary, within the 45-day identification period; and 180 days from the date of the sale of the relinquished property to close on the purchase of the replacement property.

This timeline is set by the IRS and it's important to note that these timelines are strict. Failure to comply with them can result in the loss of the 1031 Exchange tax deferment and the payment of capital gains taxes on the sale of the relinquished property.

The taxpayer must follow the required steps and timelines of the 1031 Exchange process, including the identification of the replacement property, the closing of the sale of the relinquished property, the acquisition of the replacement property, and the filing of Form 8824 with the IRS.

What are the financial requirements of a 1031 Exchange?

The financial requirements of the 1031 Exchange tax deferment provision include:

#1. Equal or greater value: The replacement property must be of equal or greater value than the relinquished property in order to qualify for the 1031 Exchange tax deferment.


#2. Like-kind: The replacement property must be like-kind to the relinquished property, meaning it must be of a similar type or character. For example, a rental property can be exchanged for another rental property, but not for a personal residence.


#3. Investment or business purpose: The replacement property must be held for investment or business purposes, and not for personal use.


#4. No actual or constructive receipt of funds: The taxpayer must not have actual or constructive receipt of the funds from the sale of the relinquished property, as this would trigger the payment of capital gains taxes. The qualified intermediary holds the funds in an escrow account until they are used to purchase the replacement property.

How is an investment property defined?

In the Internal Revenue Code Section 1031, an "investment property" is defined as any property held for investment purposes, such as rental property, land, or other real estate held for the purpose of earning income or appreciation. The definition of an investment property in the context of a 1031 exchange is broad and can include most types of real estate, as long as the property is held for investment purposes and not for personal use. In order to qualify for a 1031 exchange, the property being sold and the replacement property must both be investment properties and must be of a like-kind," meaning they must be similar in nature or character, even if they are not identical.

What is a “qualified intermediary” in a 1031 Exchange?

An intermediary, also known as a qualified intermediary, is a third-party facilitator who plays a critical role in a 1031 Exchange. The intermediary acts as a go-between for the taxpayer and the exchange of the properties, ensuring that the exchange complies with the relevant tax laws and regulations.

In a 1031 Exchange, the taxpayer must transfer the proceeds from the sale of the relinquished property to the qualified intermediary, who holds the funds until they are used to purchase the replacement property. This helps to ensure that the taxpayer does not have actual or constructive receipt of the funds, which would trigger the payment of capital gains taxes.

The qualified intermediary must be an unrelated party to the exchange and must have a written agreement with the taxpayer that outlines the terms and conditions of the exchange.


The intermediary must also provide the taxpayer with a signed statement indicating that the exchange has been completed in accordance with the 1031 Exchange provisions of the tax code.

It's important to work with a reputable and experienced qualified intermediary who can help guide you through the 1031 Exchange process and ensure compliance with the relevant tax laws and regulations.

How do I find a replacement property during a 1031 Exchange?

There are several ways to find a replacement property for your 1031 Exchange tax deferment, including:

#1. Working with a real estate agent: A real estate agent can help you identify properties that meet your investment criteria and help you navigate the 1031 Exchange process.


#2. Utilizing online resources: There are many websites and online resources that allow you to search for investment properties, including online real estate listings and real estate investment platforms.


#3. Networking with other real estate investors: Joining a local real estate investment club or networking with other real estate investors can provide you with valuable insights into potential investment opportunities and help you find the right property for your 1031 Exchange.


#4. Attending real estate investment events: Attending real estate investment events, such as trade shows and seminars, can provide you with valuable information on the latest investment trends and opportunities, and help you connect with other real estate investors and professionals.

Ultimately, finding the right replacement property for your 1031 Exchange requires careful research and planning, as well as a clear understanding of your investment goals and objectives. If you’re working with a trusted and experienced professional, as mentioned previously, they can help guide you through the process and ensure compliance with the relevant tax laws and regulations.

Am I required to purchase one of the replacement properties I selected for my 1031 Exchange?

No, you are not required to purchase a property that you have identified as a potential replacement property under the 1031 Exchange tax deferment provision. The identification of potential replacement properties is simply a requirement of the 1031 Exchange process that allows you to signal your intention to defer taxes on the sale of your relinquished property, and you can change your mind and choose a different property as long as you do so within the required time frame.

How long does my home have to be an investment property before I can perform a 1031 exchange?

There is no minimum length of time that a property must be held as an investment property before it can be eligible for a 1031 Exchange. The primary requirement is that the property being sold and the property being acquired must be held for investment or business purposes, not for personal use.

REMINDER: The IRS will closely examine the intent of the taxpayer to determine whether the property is being held for investment or business purposes, and it's important to be able to demonstrate that the property was not used for personal purposes in the past two years.

When should I set up my escrow account during a 1031 Exchange?

You should set up your escrow account with your qualified intermediary as soon as possible after you have entered into a contract to sell your relinquished property and before the sale of the property is closed. The qualified intermediary will typically provide you with instructions and forms to complete, including a deposit agreement and a power of attorney, which will allow the intermediary to act on your behalf in holding and managing the proceeds from the sale of the relinquished property.

What happens if you don’t purchase a replacement property within the 180-day deadline, during a 1031 Exchange?

If you do not purchase a like-kind property within the 180-day deadline for a 1031 Exchange, you will not be able to complete the exchange and defer the payment of taxes on the sale of the relinquished property.

The amount of the gain will be equal to the difference between the sales price of the relinquished property and its tax basis, which is the original cost of the property plus any capital improvements.

It's important to adhere to the strict deadlines of the 1031 Exchange which is why you should work closely with a qualified intermediary to ensure that the replacement property is acquired within the required time frame.

If you are unable to find a suitable replacement property within 180 days, it may be possible to extend the deadline by seeking a private letter ruling from the IRS, but this can be a complex and time-consuming process.

How many times can I take advantage of the 1031 Exchange provision?

There is no limit on the number of times you can take advantage of the 1031 Exchange tax deferment provision. You can defer the payment of taxes on the sale of investment or business properties by exchanging them for like-kind properties as many times as you want, provided that you comply with all of the requirements of the 1031 Exchange, including the timing of the exchange, the like-kind nature of the properties, the equal or greater value of the replacement property, the investment or business purpose of the properties, and the use of a qualified intermediary.

Cliff-notes to the 1031 Exchange Tax Deferment Provion:

#1. Timing: You must follow the required timelines for identifying and acquiring the replacement property. If you miss the deadlines, you will not be able to complete the 1031 Exchange and defer the payment of taxes.

#2. Like-kind property: The replacement property must be of a similar type or character as the relinquished property, and must be held for investment or business purposes, not personal use.
Value: The replacement property must be of equal or greater value than the relinquished property.

#3. No actual or constructive receipt of funds: You must not have actual or constructive receipt of the funds from the sale of the relinquished property. The qualified intermediary holds the funds in an escrow account until they are used to purchase the replacement property.

#4. Qualified intermediary: You must work with a qualified intermediary who is experienced in 1031 Exchanges and can ensure that the exchange complies with the relevant tax laws and regulations.

#5. Documentation: You must keep accurate records and provide the required documentation, including Form 8824, to the IRS to support the 1031 Exchange.

#6. Professional advice: It's advisable to seek the advice of a tax professional or financial advisor to ensure that the 1031 Exchange is completed correctly and that you fully understand the implications of the exchange.

#7. Overall - and lastly - it's important to carefully consider your options and choose a replacement property that meets your investment goals and objectives, as the 1031 Exchange process can be complex and difficult to undo once it has been initiated. Plan as much as you can prior to the closing of your relinquished property so that you aren’t rushed into decisions and poor investments. The downside could cost you more than the gains tax.

The 1031 Exchange process is a great way to defer the payment of taxes on the gains from your relinquished investment property. Working closely with a qualified intermediary and a tax professional or financial advisor who is experienced in 1031 Exchanges, to determine the like-kind nature of the properties being exchanged, will ensure that the exchange is completed correctly and in compliance with all of the requirements of the 1031 Exchange.

The steps and timeline of a 1031 Exchange Tax Deferment Provion:

#1. Set up your escrow account with a qualified intermediary when you go under contract on your relinquished property.


#2. Perform research and planning for your replacement property, during (and before) your contract period.


#3. Submit 1 or more properties that would qualify as replacement properties, as well as form 8824, to your qualified intermediary, within 45 days after closing on your relinquished property.


#4. Close on the purchase of your replacement property within 180 days of the closing for your relinquished property.


That's it, your taxes are deferred!


If you’d like to know how you can never pay taxes on your gains, look out for our next blog post on How to Build Generational Wealth: Leveraging 1031 Exchanges and Inheritance Tax Law.