If you are seeking this guidance because you are in a contested situation with the IRS, such as dealing with a notice of a mistake on your tax return, or even asking to explain a certain entry, then you should read and understand Internal Revenue Code Section 1031(a)(1) and Treasury Regs Section 1.1031(a)-1.
But if you are just wanting to learn the 1031 Exchange Rules so that you can do your own 1031 Exchange, I will show you all of the Rules that you need to know, for now.
The Section 1031 Exchange Rules that you need are the ones that I will list below.
And if you scroll down the page, I will show you how they work, including actual transactions.
Exchange Rules Summary
There are nine basic 1031 exchange rules that you need to guide you. and then there are six additional rules that will expand your understanding of the Section 1031 process.
Let’s start with the basics.
1. Like Kind Property
The property that you sell, your Relinquished Property, will be either real property, or it will be real property combined with personal property.
The property that you buy, your Replacement Property, will be either real property, or it will be real property combined with personal property.
The personal property we are talking about here is “tangible personal property” and not your personal possessions.
Tangible personal property is the portion of the real estate that is not part of the basic structure. These are items like the furniture and fixtures, and heating and air conditioning systems.
They are items with a depreciable life of 20 years or less.
The Tax Cuts And Jobs Act (TCJA) eliminates the use of the Section 1031 Like Kind Exchange for personal property. It now only applies to real property. The real properties must be “like-kind” to each other.
This does not mean that the real properties are “like” in appearance, but are “like” in their use or characterization, such as both being used as business or investment properties.
2. Business or Investment Property
The next 1031 Exchange Rule requires that the Relinquished Property be “property held for productive use in a trade or business or for investment.” That refers to what you are using your property for right now.
The Replacement Property, however, must be property “which is to be held either for productive use in a trade or business or for investment.” That refers to what you use the property for after you buy it.
An explanation of which properties meet this definition can be found at Dealer Property, and expanded on at Intent.
3. Replacement Property Price
The price that you pay for the Replacement Property must be equal to, or greater than, the sales price of the Relinquished Property in order to qualify for a Total Tax Deferral. If it is less, you can still qualify for a Partially Tax Deferred Section 1031 Exchange.
4. Net Sales Proceeds
This is the amount that you are entitled to received at the closing on the sale of your Relinquished Property.
The 1031 Exchange Rules require that all of your Net Sales Proceeds be used in the purchase of your Replacement Property.
If you take out part of the Net Sales Proceeds at the Closing, that part will be taxable to you as “boot.”
5. Same Taxpayer
The name that goes on the deed when you receive the Replacement Property must be the same name that was put on the deed for the Relinquished Property when you bought it. It can be your name as an individual, or an LLC, a C or sub-S corporation, a Partnership, etc.
However, if you sell the Relinquished Property as an individual, and you buy the Replacement Property in the name of an LLC in which you are the sole member, and you have elected to be treated by the IRS for tax purposes as a Disregarded Entity, the seller and buyer are considered to be the same under the 1031 Exchange Rules.
6. 45-Day Period
This is the first of the two “1031 Exchange Timelines.”
The date on which you close on the sale of your Relinquished Property is called the “Exchange Date.”
Within 45 days from this date, you must identify in writing the property that you intend to purchase as your Replacement Property.
You have three ways to do this.
First, you can identify up to three properties without regard to the value of each, or the total value of all three.
Or, you can identify as many properties as you want as long as the total value of all of the properties is not more than 200% of the value of the Relinquished Property.
And finally, the most complicated of the 1031 Exchange Rules, you can identify as many properties as you want, without regard to the “200%” limitation, as long as you end up closing on enough of the properties to represent 95% of the total value of all of them. This option is seldom used because it is so difficult to understand and to follow.
7. 180-Day Period
This is the second of the two “1031 Exchange Timelines.”
Within 180 days after the Exchange Date, you must close on the purchase of your Replacement Property.
If you do not close within this time,
- the entity holding your Net Sales Proceeds will distribute those funds to you,
- you will not be permitted to engage in a Section 1031 Exchange, and
- you will pay Capital Gains and Depreciation Recapture Tax on the sale.
The IRS will not impose penalties or interest.
8. Related Party
The 1031 Exchange Rules say that you cannot sell your Relinquished Property to, or buy your Replacement Property from, a person related to you, a related party, without having certain conditions imposed.
A “Related Party” is your spouse, your brother, your sister, your child, your grandchild, your parent, or your grandparent.
It also includes a corporation, partnership, Limited Liability Company, or similar business entity in which you own more than 50% of the interest. This percentage includes your spouse’s ownership.
Related Parties are allowed to do a direct swap of properties, but each party must hold the acquired property for a period that is more than two years after the date of the last transfer.
Also, each Related Party must continue to file Form 8824 for two years following the year of the Exchange.
You can sell your Relinquished Property to a Related Party, but the Related Party is required to hold the property for the two year period described above.
If the Related Party fails to do so, the transaction will be declared invalid under the 1031 Exchange Rules, and taxes, penalties, and interest will be imposed on both parties.
You will be held to the same two-year filing requirement for Form 8824, except that it could turn into three years for you because the period will start to run from the date that you acquire your Replacement Property, and this could be 180 days after the first closing, and could cover three tax-filing periods.
You are not prohibited from buying Replacement Property from a Related Party, with the same two-year reporting requirement for Form 8824, but it almost guarantees that the IRS will audit the transaction because this is where they find most of the abuse of the Section 1031 Exchange, family members trying to game the system. So, this is where they are looking.
9. Qualified Intermediary
The most important of the 1031 Exchange Rules is that you cannot have actual receipt of, or constructive receipt of, or control over the Net Sales Proceeds.
You must sign an Assignment of Benefits of your sales contract on your Relinquished Property to an independent third party.
Usually this is a Qualified Intermediary.
The name does not mean that the individual or entity is “qualified” in any way to do anything, and they often are not qualified.
A Qualified Intermediary (QI) is an entity that is not disqualified from providing the service by reason of having had a family or business relationship with you during the past two years.
Think about that. It is the crux of the problem. The IRS considers anyone who has not been disqualified as being “qualified.”
That is not the definition of “qualified.”
So the only reason that they are called qualified (intermediary) is that they are not disqualified by the definition.
It has nothing to do with their ability to do the job.
The QI is not licensed, or even registered, by the IRS, or any other federal government regulatory agency.
The IRS, in their Tax Gap series fact sheet, even warns about them:
“Be careful in your selection of a qualified intermediary as there have been recent incidents of intermediaries declaring bankruptcy or otherwise being unable to meet their contractual obligation to the taxpayer. These situation have resulted in taxpayers not meeting the strict timelines set for a deferred or reverse exchange, thereby disqualifying the transaction from Section 1031 deferral of gain. The gain may be taxable in the current year while any losses the taxpayer suffered would be considered under separate code sections.”
This is the IRS telling you that if you turn over $400,000 from the sale of your Relinquished Property to your QI to be used in the purchase of your Replacement Property, and the money disappears, you not only lose out on the Replacement Property, you’ve lost your Relinquished Property, your money is gone, and you still owe the IRS the Capital Gains Tax.
Additional Exchange Rules
1. Elections
When you sell your Relinquished Property, you will still have some basis in it that you have not depreciated (unless you have held it for 27.5 years, which you probably have not.)
You are permitted under the 1031 Exchange Rules to continue to claim depreciation on this amount even though you no longer own the property.
But you must make an IRS “Election” on how you want to do something else.
You can either continue with your current depreciation schedule and claim whatever depreciation amount you are entitled to each year. Call your depreciation schedule “Old Basis.”
You would now have a new depreciation schedule for your basis in the Replacement Property and call it “New Basis.”
Or, you can combine the basis in the Relinquished Property, it is called Transferred Basis, with the basis in the new Replacement Property, and start a completely new depreciation schedule.
But you must tell the IRS which one you are doing. You do that by checking the appropriate box on your Form 4562 that says, “Election Made Under Section 1.168(i)-6T(i).”
2. Debt Replacement
There is a mistaken belief that the mortgage on the property that you buy, your Replacement Property, must be at least as much as the mortgage that was paid off on the property that you sold, your Relinquished Property.
This is incorrect.
A complete reading of the rule shows that it says that the difference can be made up by adding cash.
Well, if you think about it, this will have to happen anyway. After putting all of the Net Sales Proceeds (or as much as you intend) into the Replacement Property, the rest of the purchase price will have to be made up of either debt or cash.
If your seller is willing to finance your purchase, see Seller Financing.
You can read the rule at Treasury Regulation 1.103(d)-2.
3. Partially Tax Deferred Exchange
The 1031 Exchange Rules also permit an Exchange that is not fully tax deferred. If you take a distribution of part of your Net Sales Proceeds, that part will become taxable to you, while the remainder can still be used in the Like Kind Exchange. All of the other rules still apply.
The portion that is taxable will be taxed as Capital Gains and the tax due will be determined by the amount of Depreciation Recapture you are liable for, because that will be applied first, before the capital gains tax.
And the Depreciation Recapture tax rate for Straight-line Depreciation Recapture will be applied, and, then, the standard capital gains tax rate.
4. Assumed Mortgages
The 1031 Exchange Rules permit you to assume the existing mortgage on the property you buy, your Replacement Property, just like it permits you to sell your Relinquished Property and have the Buyer assume your mortgage.
If the Buyer assumes your mortgage, you have received “boot” in the amount of the mortgage balance, and this is taxable to you.
However, this amount can be offset by the amount of any mortgage that you assume when you purchase the Replacement Property, or by any new cash that you put into the purchase.
You can assume the mortgage on property that you buy, and you will not be penalized, as long as you follow all of the other rules, such as using all of your Net Sales Proceeds in the purchase.
5. Seller Financing
If you take back a note, full or partial, when you sell your Relinquished Property, that note is considered “boot” and will be taxable to you the same as cash.
Since it will be an Installment Note, each payment will be a combination of interest and principal, and will be taxable income in the year received.
The interest will be taxable at your ordinary income tax rate. But the principal will be taxable based on what it represents, Depreciation Recapture or Capital Gains.
If you only finance a portion of the sale price, the remainder can be qualified as a Section 1031 Exchange.
Under the 1031 Exchange Rules, there is a way that you can do seller financing and still not have to pay taxes, and I will discuss it in detail below.
But briefly, it would involve making the note payable to your QI instead of payable to you.
Then you can arrange for the Seller of your Replacement Property to take the note as part of the purchase price.
Alternatively, you could make the note payable in less than 180 days, and when you close on your Replacement Property, your QI will have cash instead of a note.
6. Boot
This is what the IRS calls anything that you receive in exchange for your Relinquished Property that is not like kind property and is not cash.
It will usually be taxable to you.
We have discussed how an assumption of your mortgage can be boot, but there are other possibilities. You might receive a coin collection, a boat, or a motor home.
None of these qualify as like kind property, and they are not cash, so their value will taxable as boot.
The only good thing about this is that you and the other party can generally agree on what the fair market value of the item is, and the IRS will usually accept this valuation.
But, as stated earlier, you can offset the boot by adding an equivalent amount of cash to your Net Sales Proceeds in purchasing your Replacement Property.
In fact, you can even add something other than cash, like a boat, and then you can “net the boot.”