Section 1031 Like-Kind Exchanges

Key requirements

Both properties must be held for productive use in a business or for investment, so a personal residence and property held mainly for resale do not qualify. Most U.S. real property is like-kind to other U.S. real property, but U.S. and foreign real property are not.

Deferred exchanges

In a typical deferred exchange, a qualified intermediary holds the sale proceeds. The seller must identify replacement property within 45 days and acquire it within 180 days, or by the return due date if earlier. These deadlines are strict, and the taxpayer must not receive the cash.

Boot and basis

Cash received or debt relief that is not offset can be taxable boot. Gain is recognized up to the amount of boot. To defer fully, an investor generally reinvests all net proceeds and acquires property of equal or greater value and debt.

The basis of the old property generally carries over to the new property, so the gain is deferred rather than excused. Exchanges are reported on Form 8824. Related-party exchanges have a two-year holding rule, and depreciation recapture needs careful review.

How a deferred exchange works, step by step

First, the investor engages a qualified intermediary before closing the sale. Second, the sale proceeds go to the intermediary, not the investor. Third, the investor identifies replacement property in writing within 45 days. Finally, the intermediary uses the funds to buy the replacement property within 180 days.

The intermediary cannot be the investor's recent agent, such as their attorney, accountant, or employee, except in limited situations. Choosing a reputable, secure intermediary matters, because that party holds the funds.

Identification rules

An investor generally must meet one of three tests. The three-property rule allows up to three properties of any value. The 200% rule allows any number of properties if their total value is no more than twice the value of the property sold. The 95% rule allows any number, but the investor must buy at least 95% of the identified value.

A worked example

An investor sells a property for $1 million with a basis of $400,000 and no debt, so the gain is $600,000. They reinvest $900,000 in a replacement property and keep $100,000 in cash. The $100,000 is boot, so $100,000 of gain is recognized and $500,000 is deferred.

The basis of the new property is $400,000. That equals the $900,000 cost minus the $500,000 deferred gain. Replacement debt matters as well: if debt on the new property is lower than on the old one, the difference can also count as boot, unless offset by new cash.

Reverse and improvement exchanges

In a reverse exchange, the replacement property is acquired before the old one is sold. Revenue Procedure 2000-37 provides a safe harbor using an exchange accommodation titleholder, with similar 45-day and 180-day timelines. An improvement exchange uses exchange funds to build on the replacement property.

Common traps

Vacation homes need care, although Revenue Procedure 2008-16 offers a safe harbor with limits on personal use. Property bought mainly to resell quickly may fail the held-for-investment test. Partnerships cannot exchange a partnership interest, and partners who want to go separate ways often face drop-and-swap issues.

Selling costs paid from proceeds, such as commissions, usually do not create boot, but loan payoffs and some other items can. States can also follow their own rules. California, for example, tracks gain deferred on California property exchanged for property elsewhere.

Deferral can last for years through repeated exchanges. If the property is held at death, Section 1014 generally steps the basis up to fair market value, so the deferred gain may never be taxed.

A preparer's checklist

Before the sale closes, confirm that the property is held for business or investment, and that an independent qualified intermediary is engaged. Check the sale contract for language that allows the exchange.

Diary day 45 and day 180 from the closing date, and compare the 180th day with the return due date, extending the return if needed. Compare the sales price, debt, and cash in the old and new properties to estimate boot.

After closing, complete Form 8824, calculate the new basis, and update the depreciation schedule. Check any state reporting requirement, and keep the closing statements and identification notice in the permanent file.

Frequently asked questions