What Is a 1031 Exchange? Definition and Rules

If you’re thinking of selling a piece of property that could result in a big profit and a big tax bill, a 1031 exchange could be a useful strategy.

A 1031 exchange, named after section 1031 of the U.S. Internal Revenue Code, is a way to postpone capital gains tax on the sale of a business or investment property by using the proceeds to buy a similar property. It is also sometimes referred to as a "like-kind" exchange.

A key rule about 1031 exchanges is that they’re generally only for business or investment properties. Property for personal use, such as your home, or a vacation house, typically doesn’t count. Securities and financial instruments, such as stocks, bonds, debt instruments, partnership interests, inventory and certificates of trust also usually aren’t eligible for 1031 exchanges.

» MORE: How capital gains tax works on home sales

A 1031 exchange can be complex, so you'll likely want to consult with a qualified tax pro. You can read the rules and details in IRS Publication 544, but here are some basics about how a 1031 exchange works and the steps involved.

Step 1: Identify the property you want to sell

A 1031 exchange is generally only for business or investment properties. Property for personal use — like your primary residence or a vacation home — typically aren't eligible.

Step 2: Identify the property you want to buy

The property you’re selling and the property you’re buying has to be "like-kind," which means they’re of the same nature, character, or class but not necessarily the same quality or grade (more on that below). Note that property inside the U.S. isn’t considered like-kind to property outside the U.S^[0]

Step 3: Choose a qualified intermediary

If you don’t receive any proceeds from the sale, there’s no income to tax — that’s generally the idea behind a 1031 exchange.

One way to make sure you don't receive cash prematurely is to work with a qualified intermediary, sometimes called an exchange facilitator. Basically, they hold the funds in escrow for you until the exchange is complete (assuming the sale and the purchase don’t take place simultaneously). Choose carefully. If they go bankrupt or flake on you, you could lose money. You could also miss key deadlines and end up paying taxes now rather than later.

Step 4: Decide how much of the sale proceeds will go toward the new property

You don’t have to reinvest all of the sale proceeds in a like-kind property. Generally, you can defer capital gains tax only on the portion you reinvest. So if you keep some of the proceeds, you might end up paying some capital gains tax now.

Step 5: Keep an eye on the calendar

For the most part, you have to meet two deadlines or the gain on the sale of your property may be taxable.

• First, you have 45 days from the date after you sell your property to identify potential replacement properties. You have to do that in writing and share it with the seller or your qualified intermediary.

• Second, you have to buy the new property no later than 180 days after you sell your old property or after your tax return is due (whichever is earlier).

Step 6: Be careful about where the money is

Remember, the whole idea behind a 1031 exchange is that if you didn’t receive any proceeds from the sale, there’s no income to tax. So, taking control of the cash or other proceeds before the exchange is done may disqualify the deal and make your gain immediately taxable.

Step 7: Tell the IRS about your transaction

You’ll likely need to file IRS Form 8824 with your tax return. That form is where you describe the properties, provide a timeline, explain who was involved and detail the money involved.

Need to call in a pro? How to find a tax CPA near you

Here are some of the notable rules, qualifications and requirements for like-kind exchanges.

• You still have to pay tax, just later. A 1031 exchange doesn’t make capital gains tax go away; it just postpones it. A capital gains tax bill will come due at some point, so prepare for that. However, if a 1031 property remains unsold at the time of the owner's death, heirs of the property may be able to minimize or altogether avoid the tax implications via a stepped-up cost basis.

• The properties don’t have to be as similar as you may think. You don’t necessarily have to swap a rental property for an identical rental property or a parking lot for a parking lot. "Like-kind" generally means you’re swapping one investment property for another investment property (again, be sure to see a qualified tax pro before taking action). It might be possible to exchange vacant land for a commercial building, for example.

• Relationships matter. Your qualified intermediary or exchange facilitator can’t be a relative, your attorney, banker, employee, accountant or real estate agent. People who have served you in any of those capacities in the past two years are also off-limits. And you can’t be your own qualified intermediary.

» MORE: Rental property tax deductions to know about

Here are four kinds of 1031 exchanges: simultaneous, deferred, reverse and improvement. The rules for each type can get particularly complex, so see a tax pro for help or guidance if you are considering a 1031 exchange.

Simultaneous exchange

In a simultaneous exchange, the buyer and the seller exchange properties at the same time.

Deferred exchange (or delayed exchange)

In a deferred exchange, the buyer and the seller exchange properties at different times. However, the sale of one property and the purchase of the other property have to be "mutually dependent parts of an integrated transaction."

Reverse exchange

In a reverse exchange, you buy the new property before you sell the old property. Sometimes this involves an "exchange accommodation titleholder" who holds the new property for no more than 180 days while the sale of the old property takes place.

Improvement exchange

This exchange allows a taxpayer to use profit from the sale of an existing property to fund improvements to, or building of, a new property. This type of exchange, sometimes also called a construction exchange or built-to-suit exchange, can be especially tricky to navigate, so again, make sure to consult with a tax pro.