1031 Exchange Explained: Defer Capital Gains Indefinitely
A 1031 exchange (also called a like-kind exchange) allows real estate investors to defer capital gains tax by reinvesting the proceeds from a property sale into a similar property. When executed correctly, it can defer taxes indefinitely.
How It Works
Under Section 1031 of the Internal Revenue Code, if you sell an investment property and reinvest the proceeds into a like-kind property, you can defer both federal and state capital gains tax on the sale.
Tax Deferred
100%
of federal and state capital gains when properly executed
Key Rules
Timeline Requirements
- 45-day identification period: You must identify potential replacement properties within 45 days of closing the sale
- 180-day exchange period: You must close on the replacement property within 180 days
Qualified Intermediary
You cannot touch the funds. A qualified intermediary (QI) must hold the proceeds between the sale and purchase. Setting up the QI before closing is essential.
Like-Kind Requirement
The replacement property must be like-kind, which for real estate is broadly defined. You can exchange a rental house for an apartment building, or vacant land for a commercial property. However, your primary residence does not qualify.
Value Requirements
To defer 100% of the gain, the replacement property must be equal to or greater in value than the property sold, and you must reinvest all the proceeds.
Common Mistakes
- Missing the 45-day identification deadline
- Not using a qualified intermediary
- Taking constructive receipt of the funds
- Trying to exchange a primary residence (not allowed)
- Boot (receiving cash or non-like-kind property)
Can You 1031 Exchange Into Your Primary Residence?
Not directly. However, you can exchange into a rental property and later convert it to your primary residence after renting it for at least 2 years. After living in it for 2 years, you may also qualify for the $250K/$500K exclusion.
The Bottom Line
A 1031 exchange is the most powerful tax deferral tool for real estate investors. With proper planning and a qualified intermediary, you can defer hundreds of thousands in capital gains tax.