How a 1031 Exchange Works, Step by Step

A 1031 exchange has a handful of rules that matter a lot. Miss one and the tax can come due. Here they are in the order you will meet them.

Step 1: Confirm the Property Qualifies

Section 1031 applies to real property held for productive use in a trade or business or for investment, exchanged for like-kind real property you will also hold that way.

• Real property only. Since the 2017 tax law, which applies to exchanges completed after December 31, 2017, Section 1031 covers real property only. Equipment and other personal property no longer qualify.
• Like-kind is broad. Investment real estate can generally be exchanged for other investment real estate, such as a rental house for a retail building.
• Not your home. A personal residence does not qualify.
• Not inventory. Property held primarily for sale, like homes a builder flips, does not qualify.
• U.S. for U.S. Real property in the United States and real property outside the United States are not like kind.

Step 2: Line Up a Qualified Intermediary Before You Close

In most exchanges, you sell first and buy later. The danger is touching the money in between. If you actually or constructively receive the sale proceeds, the exchange can fail. Constructive receipt includes money credited to your account, set apart for you, or otherwise made available to you.

A qualified intermediary (QI) solves this. Under the IRS safe harbor, the QI enters a written agreement with you, takes part in the sale of your old property and the purchase of the new one, and holds the funds in between. The agreement must limit your right to receive, pledge, borrow, or otherwise get the benefit of the money before the exchange period ends, with narrow exceptions.

Who cannot be your QI

Some people are "disqualified persons." These include your agent at the time of the transaction, and anyone who acted as your employee, attorney, accountant, investment banker or broker, or real estate agent or broker during the 2 years before you transfer the first property you are selling. There are limited exceptions for routine services, such as title, escrow, and certain financial services. In practice, this means your own real estate agent, CPA, or attorney who worked for you recently generally cannot act as your QI.

Step 3: Sell Your Property

Closing on your sale starts two clocks at the same time.

Step 4: Identify Replacement Property Within 45 Days

You must identify replacement property by midnight on the 45th day after you transfer the property you sold. Weekends and holidays count.

The identification must be in writing, signed by you, and delivered to the seller of the replacement property or another person involved in the exchange who is not a disqualified person, such as your QI.

How many properties you can identify

You pick one of these rules:

• 3-property rule. Identify up to three properties, regardless of value.
• 200% rule. Identify any number of properties, as long as their total fair market value does not exceed 200% of the value of the property you sold.
• 95% rule. If you go over both limits, the exchange can still qualify only if you actually acquire at least 95% of the total value of everything you identified.

Most owners use the 3-property rule because it is simple.

Step 5: Close on Replacement Property Within 180 Days

You must receive the replacement property by the earlier of two dates:

• 180 days after you transfer the property you sold, or
• the due date of your tax return for the year of the sale, including extensions.

The 45 days run inside the 180 days. They are not added together. If your sale closes late in the year, your return due date can cut the window short unless you extend your return. Ask your CPA about this early.

Step 6: Watch Out for Boot

"Boot" is anything you receive that is not like-kind real property. Gain is recognized up to the amount of boot. Two kinds trip people up:

• Cash boot. Any sale proceeds you keep, or that get used for non-exchange items, can be taxable.
• Mortgage boot. If the debt on your new property is lower than the debt paid off on your old one, the debt relief is treated like money received.

The equal-or-greater guideline

Because cash you keep and debt you shed can be taxed, owners who want full deferral generally aim to: - buy replacement property of equal or greater value, - reinvest all of the net proceeds, and - take on equal or greater debt, or ask their CPA whether adding cash can make up the difference.

Step 7: Be Careful With Related Parties

Exchanges with related persons, such as certain family members or entities you control, carry an extra rule. If either side disposes of the exchanged property within 2 years, the deferral can be lost, with limited exceptions. Get advice before doing any exchange with a relative or your own company.

Step 8: Report the Exchange

Federal: exchanges are reported on IRS Form 8824.

California: if you exchange California real property for property located outside California, you must file FTB Form 3840 for the year of the exchange and for each later year, generally until the deferred California-source gain is recognized. This applies regardless of where you live. The deferred gain is recognized when you later sell the replacement property in a taxable sale. People often call this the California "clawback." If you do not file as required and do not file a return, the FTB may estimate your income and assess tax, penalties, and interest.