1031 Exchange: What It Is and How to Use It

Learn the basics of the 1031 Exchange Document.

The IRS 1031 Exchange document serves as a tax filing mechanism that grants real estate investors the opportunity to defer capital gains tax on property sales, provided they reinvest the proceeds in qualified manners. Referred to as a 1031 Exchange due to its association with IRC Section 1031 of the IRS code, this strategy is often overlooked despite being one of the most potent methods to preserve capital strength within a real estate investment portfolio. It offers commercial and rental real estate investors a distinct advantage over traditional investment approaches that are typically subject to capital gains tax.

What Is a 1031 Exchange?

According to the IRS, a 1031 exchange allows you to defer paying taxes on the gain from the sale of a property if you reinvest the proceeds in a similar property as part of a qualifying like-kind exchange.

The definition provided by the IRS highlights two key elements of a 1031 exchange: (1) the involvement of a qualified intermediary, and (2) the requirement for a like-kind exchange.

In a Standard 1031 Exchange (selling first, buying later), a qualified intermediary acts as an account holder who receives the proceeds from the sale of your relinquished property and holds them in an account until the acquisition of the replacement property. In a Reverse 1031 Exchange (buying first, selling later), the qualified intermediary holds the title to the purchased property until the relinquished property is sold, ensuring that the funds remain sheltered from capital gains tax in both scenarios.

A like-kind exchange entails both the relinquished property (the property being sold) and the acquired property (the property being purchased) being held for use in a trade or business investment. Properties primarily used for personal purposes, such as a primary residence, second home, or vacation home, do not qualify for like-kind exchanges.

What is the Timeframe of a 1031 Exchange?

A 1031 Exchange entails two crucial time limits that participants must adhere to.

The first time limit is the 45-day identification period, which begins from the date the property is relinquished. During this period, the owner must personally identify potential replacement properties by signing a document that clearly identifies them.

The second time limit pertains to the completion of the exchange. The replacement property (or relinquished property in the case of a reverse exchange) must be received, and the entire exchange process must be finalized within 180 days after the sale of the exchanged property or by the due date (including extensions) of the income tax return for the tax year in which the relinquished property was sold—whichever date comes earlier.

What Properties Qualify for a 1031 Exchange?

Properties that do not qualify for a 1031 Exchange include:

Inventory or stock in trade
Stocks, bonds, or notes
Other securities or debt
Partnership interests
Certificates of trust

Conclusion

Read more about the specifics of the IRS policy on the 1031 Exchange here. You can find more information about how the IRS treats conditions such as abandonments, foreclosures, inheritances, and opportunity zones in their recently published handbook Sales and Other Dispositions of Assets: For Use in Preparing 2023 Returns.