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IRC 1031 | Tax-deferred like-kind exchange

by | Jun 19, 2025


IRC 1031 Like-kind exchange

By: Barry E. Haimo, Esq.

June 19, 2025

What is a 1031 Like-Kind Exchange?

At its core, a 1031 exchange, named after Section 1031 of the Internal Revenue Code, allows you to defer capital gains taxes when you sell an investment property and reinvest the proceeds into another “like-kind” investment property.

Normally, when you sell a property for a profit, you’d owe capital gains tax on that profit. A 1031 exchange postpones that tax obligation. It’s not tax-free, but rather tax-deferred. The idea is that if you’re merely swapping one investment for another of a similar nature, your economic position hasn’t substantially changed, so the IRS allows you to defer the tax until a later date, typically when you eventually sell a property without doing another exchange, or when your heirs inherit it.

The “Like-Kind” Requirement

This is a common point of confusion. “Like-kind” doesn’t mean “identical.” For real estate, it’s quite broad. It generally means real property held for productive use in a trade or business or for investment.

  • Examples of “Like-Kind” Exchanges:

    • Exchanging a raw parcel of land for a commercial building.
    • Selling an apartment complex and buying a single-family rental home.
    • Trading a retail strip mall for an office building.
    • Exchanging one rental property for multiple rental properties, or vice-versa.

  • What is NOT “Like-Kind” (generally):

    • Your primary residence.
    • “Flipping” properties (properties held primarily for sale, as inventory).
    • Property in the U.S. for property outside the U.S.
    • Personal property (like equipment, vehicles, art – this changed with the Tax Cuts and Jobs Act of 2017; 1031 exchanges are now limited to real property only).

Key Rules of a 1031 Exchange

The IRS has strict rules that must be followed precisely for a 1031 exchange to be valid. Missing even one deadline or detail can cause the entire exchange to fail, making the transaction fully taxable.

  • Qualified Intermediary (QI): You cannot directly receive the proceeds from the sale of your relinquished property. The funds must be held by a neutral third party known as a Qualified Intermediary (QI) or Exchange Facilitator. The QI handles the funds, ensures compliance with IRS regulations, and facilitates the transfer of properties. This is a non-negotiable requirement. Your attorney, accountant, or real estate agent cannot act as your QI.
  • Property Held for Investment or Business Use: Both the property you are selling (the “relinquished property”) and the property you are buying (the “replacement property”) must be held for investment purposes or for use in a trade or business. As mentioned, your primary residence or vacation home (unless it meets strict rental criteria) typically won’t qualify.

  • Identification Period (45 Days): From the date you close on the sale of your relinquished property, you have 45 calendar days to identify potential replacement properties. This identification must be in writing, signed by you, and delivered to your Qualified Intermediary or another party involved in the exchange. You can identify:

    • Up to three properties of any value (the “Three Property Rule”).
    • Any number of properties, provided their combined fair market value does not exceed 200% of the fair market value of the relinquished property (the “200% Rule”).
    • Any number of properties, provided you acquire at least 95% of the fair market value of all identified properties (the “95% Rule”).
  • Exchange Period (180 Days): From the date you close on the sale of your relinquished property, you have 180 calendar days (or the due date of your tax return for that year, whichever is earlier) to complete the purchase of the identified replacement property. Important: The 45-day identification period runs concurrently within this 180-day exchange period. So, you don’t get 45 days plus 180 days; it’s a total of 180 days from the initial sale.
  • Equal or Greater Value: To fully defer all capital gains tax, the replacement property (or properties) must be of equal or greater value than the relinquished property. Additionally, you must reinvest all the net equity from the sale, and the debt on the replacement property should be equal to or greater than the debt on the relinquished property. If you receive cash or reduce your debt (known as “boot”), that portion will be taxable.
  • Same Taxpayer: The taxpayer who sells the relinquished property must be the same taxpayer who acquires the replacement property. This can get complicated with entities like LLCs or partnerships, so careful planning is essential.

Benefits of a 1031 Like-Kind Exchange

  • Tax Deferral: This is the primary and most significant benefit. By deferring capital gains and depreciation recapture taxes, you keep more of your money working for you in real estate. This essentially acts as an interest-free loan from the government.
  • Increased Purchasing Power: Since you’re not paying taxes immediately, you have a larger pool of capital to reinvest. This allows you to acquire a more valuable or higher-performing property, accelerating your portfolio growth.
  • Wealth Accumulation: By repeatedly utilizing 1031 exchanges, you can compound your wealth over time. The deferred taxes from previous exchanges roll over into the basis of the new property, potentially allowing for significant long-term appreciation without immediate tax liabilities.
  • Portfolio Diversification or Consolidation: A 1031 exchange offers flexibility. You can diversify your real estate holdings by exchanging one property for several in different locations or asset classes (e.g., a single-family rental for commercial property). Conversely, you can consolidate multiple smaller properties into one larger, more manageable asset.
  • Strategic Repositioning: It allows you to move out of underperforming assets or markets and into more promising ones without incurring immediate tax consequences.
  • Depreciation Benefits: When you acquire a new property through an exchange, you get to reset the depreciation schedule for the new property (based on its new basis), which can provide ongoing tax deductions.
  • Estate Planning Advantage (“Swap Till You Drop”): This is a powerful, long-term benefit. If you hold onto your exchanged properties until your death, your heirs receive a “stepped-up basis” to the fair market value of the property at the time of your death. This means the deferred capital gains tax liability could be entirely eliminated for your heirs, allowing them to sell the property without incurring capital gains tax on the appreciation that occurred during your ownership.

Disadvantages and Risks of a 1031 Like-Kind Exchange

  • Strict Timelines: The 45-day identification and 180-day exchange periods are absolute. Missing these deadlines, even by a day, will disqualify the exchange and make the entire transaction taxable. This can create significant pressure, especially in competitive markets.
  • Complexity and Cost: 1031 exchanges are not simple transactions. They require careful planning, meticulous adherence to IRS rules, and the involvement of a Qualified Intermediary, which adds to the transaction costs (QI fees, legal fees, etc.).
  • Lack of Liquidity: To fully defer taxes, you must reinvest all the equity. This means you can’t take any cash out of the transaction without incurring a taxable event on that “boot.” If you need immediate access to funds, a 1031 exchange may not be the right choice.
  • Difficulty Finding Suitable Replacement Property: Especially in hot markets, finding a “like-kind” property of equal or greater value within the tight 45-day identification window can be challenging. This pressure can sometimes lead investors to overpay for a property or settle for a less-than-ideal asset.
  • Deferral, Not Elimination: Remember, the tax is deferred, not eliminated (unless the property is held until death). Eventually, if you sell a property outright without another exchange, those accumulated capital gains will become taxable.
  • “Boot” Can Trigger Tax: If you receive any “boot” (cash, non-like-kind property, or debt relief without equivalent replacement debt), that portion of the gain becomes immediately taxable. Careful calculation is necessary to avoid unexpected tax liabilities.
  • Basis Carryover: While you get to defer gains, the basis of your old property carries over to the new property, adjusted for any additional cash or debt. This means your depreciation schedule for the new property will be based on this adjusted, lower basis, which can result in lower depreciation deductions over time compared to a fresh purchase.
  • Increased Scrutiny: Because of the significant tax benefits, 1031 exchanges are often subject to closer scrutiny by the IRS. Proper documentation and adherence to all rules are paramount.

In conclusion, a 1031 like-kind exchange is a powerful tax deferral strategy that can significantly enhance your real estate investment portfolio. However, it’s not a “set it and forget it” tool. It requires careful planning, strict adherence to timelines, and the expertise of professionals like myself and a qualified intermediary. Before embarking on a 1031 exchange, we’ll thoroughly analyze your specific situation to determine if it’s the right strategy for your investment goals.

Author:

Barry E. Haimo, Esq.

Haimo Law

Strategic Planning With Purpose®

Email: barry@haimolaw.com

LinkedIn: http://www.linkedin.com/in/bhaimo

YouTube: http://www.youtube.com/user/haimolawtv

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