1031 Exchange Rules: Just the Facts

While this is clearly not an exhaustive list of all 1031 exchange rules, it’s a great place to start. Section 1031 of the tax code has been around for a long time and the IRS has provided various notices with highly specific guidance for specific edge case scenarios. You should definitely research these on your own and talk to a competent tax attorney before making any final decisions. Nothing in this article should be considered actual tax or legal advice!

Rule #1: Investment Property Only

Only property, “held for use in a trade or business or for investment” is eligible for a 1031 exchange under the IRS regulations. That means you can’t 1031 exchange into or out of your primary home or involve any forms of personal property like art or jewelry in your exchange. This is the most fundamental of all 1031 exchange rules.

It also holds true for the new property you acquire on the back end of the exchange. You must intend to hold it for investment purposes or use in a trade or business.

Rule #2: Hire an Exchange Facilitator

In most cases, you are explicitly not allowed to execute a 1031 exchange on your own. When you take personal control of the sale proceeds, you generally disqualify yourself from 1031 exchange eligibility. This means you should nearly always hire a “qualified intermediary” (QI), also known as an exchange facilitator. The QI performs a number of key functions, including holding the sale/purchase funds in trust, keeping sound records, and issuing various tax forms and documentation.

Rule #3: “Like-Kind” Doesn’t Mean “Exact-Kind”

1031 exchanges are also sometimes referred to as “like-kind” exchanges, in reference to the fact that the IRS requires that your replacement property be, “of the same nature, character, or class” as the disposed real estate. Those words are a bit vague, so it’s worth noting that the IRS also says, “Most real estate will be like-kind to other real estate.”

That means you can absolutely exchange a single-family rental home for vacant land or an industrial warehouse for a small office building. But you can’t exchange a partnership interest for a ranch or stocks and bonds for a self-storage facility.

Rule #4: Identify Replacement within 45-Days

Among 1031 exchange rules, this is the one that leads to the most stress and consternation among real estate investors. The rules are clear that you must “identify” your replacement property within 45 days of closing on the sale of the relinquished property. The good news is that you’re allowed to identify up to three possible properties for your new acquisition, and you can eventually close on one, two, or all three if funds allow. The bad news is that if you don’t eventually close on any of the properties on your “identified” list, regardless of the reason, your exchange fails.

The tight 45-day timeline motivates many real estate investors to do as much of the legwork of identifying (and even getting into contract on) a replacement property in advance of finalizing the initial sale transaction.

Rule #5: Close within 180-Days

The 1031 exchange closing deadline runs concurrently with the 45-day identification period, but is generally regarded as much easier to satisfy. Basically, from the day you close on the sale of your relinquished property, you have exactly 180 days (just under six months) to close on the replacement asset. Most real estate contracts close within 30-90 days, so there’s typically plenty of buffer in the 1031 exchange closing timeline.

Just remember, the replacement asset must be one (or more) of the properties on your official 45-day target list. If those three properties all become unavailable, it doesn’t matter that you still have time remaining under the 180-day period. You can’t swap in another asset after the 45-day mark either way.

Investor Tip #1: Get Paid Some Interest

One of the lesser-known secrets about 1031 exchanges is that qualified intermediaries make much of their money off the interest generated when they hold your funds. Let’s say you net $300,000 proceeds when you relinquish a property. Those funds go straight into a trust account controlled by the QI and start earning. If annual interest rates are 1.5%, the QI could earn up to $2,200 (on your money) during the 180-day window.

There’s nothing inherently wrong with this, but you should know that many investors are able to negotiate a fee discount based on the expected interest. Some QIs will even top off your 1031 exchange funds with a share of the interest income. It’s all a function of what you can negotiate.

Investor Tip #2: Never Force an Exchange

When the clock is ticking and you’re scrambling to get into contract before your 45-day window expires, it can be tempting to offer too much for a replacement property or compromise your normal due diligence process. That’s dangerous and can lead to a worse outcome than simply paying the capital gains taxes.

Be careful to avoid saddling yourself with a sub-par investment opportunity or a property that proves hard to exit in the future. If your search process doesn’t yield a viable replacement property at a decent price, it’s nearly always better to pay the taxes and move on.

Investor Tip #3: Do It While You Still Can!

Just because real estate investors have been doing 1031 exchanges since the 1930s, doesn’t mean they’ll always be an option. Trump’s 2017 tax overhaul eliminated similar exchange provisions around personal property, and Biden’s public tax plan paints a solid red bullseye on Section 1031 exchanges for real property.

With pandemic spending emptying the coffers of local, state, and the federal government, it’s more likely that taxes go up than down in the next decade. The open question is which levers the politicians will pull. It’s impossible to know for sure, so if you’re considering a 1031 exchange in the near future, you might want to kick things off sooner rather than later!