1031 exchanges: the rules that actually bind

Section 1031 of the Internal Revenue Code permits deferral of capital gain on the exchange of real property held for investment or productive use in a trade or business, where the proceeds are reinvested in like-kind property.

It is genuinely valuable. It is also procedurally strict in ways that have cost a great many investors the benefit through avoidable mistakes.

The essential requirements

Like-kind property. For real estate this is broadly interpreted — most investment real property is like-kind to most other investment real property. An apartment building can be exchanged for raw land, or a retail property for a rental house.

Note that following the 2017 tax law changes, section 1031 applies only to real property. Personal property exchanges no longer qualify.

Held for investment or business use. Primary residences do not qualify. Property held primarily for resale — a fix-and-flip — generally does not qualify, because it is inventory rather than investment property.

A qualified intermediary. This is the requirement that catches people.

You cannot receive the sale proceeds. If the funds touch your account or you have constructive receipt of them, the exchange fails entirely.

A qualified intermediary must be engaged before closing on the sale, must hold the proceeds, and must acquire and transfer the replacement property.

Engaging one after the sale closes is too late. There is no remedy.

The two deadlines

Both run from the closing date of the relinquished property, and both are strict.

Forty-five days to identify replacement property, in writing, delivered to the qualified intermediary.

One hundred eighty days to close on the replacement property, or the due date of the tax return for that year including extensions, whichever comes first.

These are calendar days, including weekends and holidays. There is no general extension for missing a deadline, though limited relief has occasionally been granted following federally declared disasters.

Forty-five days is short. It includes finding a property, negotiating, and getting it under contract in a market where you are a motivated buyer with a visible deadline — which sellers understand.

The identification rules

Three alternatives, and you must satisfy one.

The three-property rule. Identify up to three properties of any value.

The two hundred percent rule. Identify any number, provided their combined fair market value does not exceed twice the value of the relinquished property.

The ninety-five percent rule. Identify any number of any value, provided you acquire at least ninety-five percent of the total value identified.

Identification must be unambiguous — a legal description or street address — and delivered in writing within the deadline.

Achieving full deferral

To defer the entire gain, the replacement property generally must be of equal or greater value than the relinquished property, all net proceeds must be reinvested, and the debt on the replacement must equal or exceed the debt retired, unless the difference is made up with additional cash.

Any shortfall is "boot" and is taxable to the extent of the gain.

Debt reduction is the commonly overlooked form of boot. Selling a property with a $400,000 loan and buying one with a $250,000 loan creates $150,000 of mortgage boot even if all cash proceeds were reinvested.

What it defers, and what it does not

The deferred gain reduces the basis in the replacement property, which means larger depreciation recapture and gain on a future sale unless another exchange follows.

This is deferral, not forgiveness. Under current law, however, property held until death generally receives a stepped-up basis for the heirs, which is why the strategy is sometimes described as exchanging until the estate settles.

That is a description of current law, which is subject to change and which should not be the sole basis of a long-term plan.

The practical failure modes

Not engaging a qualified intermediary before the sale closes.

Failing to identify within forty-five days, or identifying ambiguously.

Being unable to find suitable replacement property in time, and buying something poor because the clock forced it.

Taking on less debt than retired without adding cash.

Related-party transactions, which have specific additional rules and holding requirements.

The most damaging is the fourth-from-last: the tax tail wagging the investment dog. Buying a mediocre property to avoid tax on a good sale frequently costs more than the tax would have.

Planning that reduces the risk

Identify potential replacement properties before listing the relinquished one.

Engage the qualified intermediary early and confirm their bonding and fund segregation practices, since intermediaries have failed and taken client funds with them.

Understand reverse exchanges, where the replacement is acquired first, which are more complex and more expensive and remove the timing pressure.

And run the numbers on simply paying the tax. Sometimes it is the better answer.

General information about United States tax concepts, not tax or legal advice. Section 1031 rules are technical and subject to change. Engage a qualified intermediary and a tax professional before undertaking any exchange.