A 1031 exchange is a powerful tax-planning tool for rental property owners—as long as investors follow the rules and timeline set by the IRS. However, the short timeframe can cause confusion, causing you to miss out on tax benefits and risk fines and penalties.
Understanding the 1031 Exchange
The 1031 exchange, also known as a like-kind exchange, is a swap of one investment property for another of equal or higher value that’s used for the same purpose. If carried out properly, the swap is a strategic move you can make to defer paying capital gains taxes.
But the advantages go beyond deferring taxes. With a like-kind exchange, you may also reap these benefits:
- Resetting your rental property’s depreciation
- Consolidating several properties into one
- Diversifying your portfolio by selling one property and buying several
- Investing in a property with a better ROI
- Paying capital gains taxes at a lower rate in the future
1031 Exchange Rules
Tax-deferment opportunities come with rules—and scams. Be wary of 1031 schemes. Some individuals promote 1031 tax exchanges as tax-free transactions. They’ll encourage the exchange of properties that don’t qualify. Or the scammers may ask the taxpayer to hold the proceeds from the sale. None of these actions comply with IRS like-kind exchange regulations. Protect yourself by knowing the six fundamental rules for 1031 exchanges.
Rule #1: Properties Must Be Like-Kind
The exchange’s foundation is that you may only swap properties similar in value and nature. However, you don’t need to find identical properties.
For example, you could make any of these swaps:
- A single-family rental property for an apartment building
- A strip mall for an unimproved lot
- A duplex for a business center
As long as the properties are for business or investment purposes, they can be part of an exchange.
Note: The IRS limits the use of like-kind exchanges for former primary residences and vacation homes. These swaps are possible under very specific conditions. Remember, this allowance focuses on investment properties.
Rule #2: You Must Use an Intermediary
The IRS requires you to use a third party, known as a qualified intermediary or exchange facilitator, during the exchange.
Proceeds from the initial property’s sale must go to the intermediary. Even though you owned the property, you may not receive the funds from the sale, even temporarily. Those funds go to an escrow account managed by your third party. This means you must have your qualified intermediary before closing on any properties.
Choose your third party wisely. Without a knowledgeable, qualified intermediary, you may lose money, miss critical deadlines, or end up paying taxes.
Rule #3: Properties Must Be in the US
Both properties for the exchange must be located in the United States. According to the IRS, properties within the US are not like-kind to properties outside the US.
Rule #4: The Timeline Is Critical
The 1031 exchange timeline is constraining, and failure to follow the timeline has serious consequences. First, the exchange itself will be invalidated, so you’ll miss the tax benefits. You may also face legal ramifications for noncompliance with the IRS regulations. Audits, penalties, and fines are also possible.
This short timeline puts pressure on all the parties involved, especially in markets with high demand. Decisions must be made quickly during an exchange, so preparation is key.
Rule #5: Acquired Properties Must Match or Exceed the Value of the Property Sold
All the net proceeds from the sale of your property must go toward purchasing the replacement. The IRS does not permit you to sell a property at a higher value, buy a less expensive property, and pocket the difference.
However, you may purchase multiple properties if the combined values meet or exceed the value of your original property. The IRS has also set guidelines for these situations. Refer to the section below on the identification period for more information.
Rule #6: One Taxpayer Must Hold Both Titles
The titleholder must be the same for both properties, or the exchange is invalid.
Comprehensive 1031 Exchange Timeline
The 1031 exchange rules timeline breaks down into three events: the sale of your property, the identification period, and the exchange period.
The critical point to remember is that the IRS permits 180 days total for the entire process. One of the most common misconceptions about like-kind exchanges is that property owners have 45 days, then 180 days, for a total of 225 days. This is not the case. You must complete the entire process within 180 days.
Beware: The 45 and 180-day rules are concurrent; the clock starts ticking for both when your relinquished property sale closes.
Day 1: Sale of Relinquished Property
The 1031 exchange timeline begins the day you sell your investment property, which is known as relinquished property. The proceeds from your relinquished property go to a third-party intermediary to be held in escrow.
At this point, both the 45- and 180-day countdowns start.
Pro tip: Hire your intermediary before you put your investment property up for sale. They’ll handle the documentation, manage the escrow funds, and provide guidance during the process.
Day 1–45: Identification Period
During this 45-day period, you must identify one or more replacement properties. All your market research, property evaluations, and analysis must be complete on day 45.
The IRS has three rules for identifying properties:
- Three property rule: You may identify up to three properties, regardless of their sale price.
- 200% identification rule: When you identify four or more properties, you must list the fair market value of each property. The total of the properties may not exceed 200% of the value of your relinquished property.
- 95% identification rule: If your identified properties are worth over 200% of the value of the relinquished property, you must close on 95% of the value of the identified properties. Otherwise, the exchange is not valid.
When you’ve picked the replacement property you want to purchase, you must identify it in writing for the intermediary. The letter must include a legal description of the property—such as a street address or distinguishable name—and your signature.
How to Prep for the 1031 Identification Period
If you’re thinking that this sounds like a lot to get done in 45 days, you’re right. The timeline for 1031 exchanges is tight, but with careful planning, you can successfully navigate the identification period.
- Start your search for replacement properties early. You aren’t required to wait until your relinquished property is on the market or sold before looking for your replacement investment.
- Engage a real estate agent to help you not only with the sale of the relinquished property but also with your search for replacements. Your agent can help you quickly identify potential properties.
- Have your qualified intermediary lined up before you put your property on the market. You don’t know how quickly a unit may sell, and you don’t want to scramble to find someone to act as your third party.
Day 46–180: Exchange Period
The next step is the exchange period, which starts on day 46. This is the 135-day maximum timeframe to close on the properties you identified during the first 45 days.
Pull out your calendar and check when your exchange period ends. If your 180-day deadline falls in the following tax year before April 15, you must close on the replacement property before you can file your taxes. If your exchange deadline falls after tax day, file for an extension so you have time to complete the exchange.
When you’re ready to close on the replacement property, your intermediary will handle the documentation and release the funds for closing. The exchange is complete once all the escrowed funds have been used to purchase replacement properties.
How to Prep for the 1031 Exchange Period
Like the identification period, the exchange period has moving parts, and timing is critical. Stay ahead with these tips:
- Look at a calendar and mark your deadlines. Does your 180-day deadline fall on a weekend or holiday? If so, you must close on your new property before then.
- Consult with your tax professional. If your exchange period spans calendar years, your tax preparer needs to know where you are in the exchange process so they can plan your tax filings or extension accordingly.
- Communicate clearly and often with your team. Your real estate agent, intermediary, and tax preparer need current information to move quickly and help you make informed decisions.
REI Hub and the 1031 Exchange
The complex rules and short timeline make like-kind exchanges challenging for investors. You need reliable data and systems throughout the process. REI Hub can help!
Our built-in financial reports help you identify which of your rentals may be good candidates for relinquished properties. We have reports at the unit, property, and portfolio levels, giving you the metrics you need to make informed decisions.
The IRS monitors like-kind exchanges closely, so accurate bookkeeping is a must. REI Hub keeps you organized during the exchange process. We’ll help you track costs associated with selling your property and securely store your receipts and documents in the cloud.
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Tips for Successfully Navigating a 1031 Exchange
A 1031 tax exchange is a fantastic tool for rental property owners. Follow these tips to ensure your exchange goes smoothly:
Do your prep work:
- Start your market research early. Clearly outline your criteria for selecting replacement investments before you put your relinquished property up for sale.
- Assemble your support team ahead of time. Once the timeline starts, you’ll need to move quickly. You can’t afford to vet real estate agents or intermediaries during the identification period.
Have regular reviews and updates:
- Communicate clearly and frequently with your team. Keep your intermediary, real estate agent, and other involved parties updated so they can provide the best advice.
- Review your progress and deadlines regularly. Set calendar reminders leading up to your deadlines.
Stay organized:
- Employ technology to use your time efficiently. Software with calendars, spreadsheets, or checklists can help you stay organized and on track.
- Maintain clear, accurate records, not only for your account books but for your property titles and exchange paperwork as well.
1031 Exchange Timeline FAQs
Can I update my list of identified properties after the 45-day deadline?
No, once the identification period ends, you can’t make changes to the list of identified properties.
What happens if I don’t identify any properties by the 45-day deadline?
If you don’t identify a property by the end of day 45, the exchange becomes invalid. The sale of your relinquished property loses the tax-deferment benefits.
What if I have funds left from the sale of my relinquished property after the 180-day deadline?
Any funds left in the escrow account after the 180-day deadline will be returned to you, and those funds are subject to capital gains and depreciation recapture taxes.
What if I don’t close on my identified property by the 180-day deadline?
If you are unable to purchase the identified property before the 1031 timeline ends, you will owe capital gains taxes and depreciation recapture taxes on the sale of your relinquished property. You will also risk potential penalties and interest on the taxes due. These costs can disrupt your investment plans and strain your cash flow.
Aside from the financial impact, a failed 1031 exchange can cause difficulties for future exchange attempts. Intermediaries may require stricter reviews, and legal costs may increase.
Does the IRS issue extensions for the 1031 timeline?
The IRS does not ordinarily permit extensions for a like-kind exchange. That’s why it’s so important to be organized and prepared before starting the process.
However, the IRS may allow extensions with presidentially declared disasters. Check with your legal and tax advisors if you think you qualify for an extension.
How often can I complete a 1031 tax exchange?
There isn’t a limit on how frequently you can do 1031 exchanges. However, it’s best to hold the replacement property for several years before selling it.
If you sell the replacement property quickly, the IRS may think you bought it for resale, not as an investment—which is the point of the transaction. Remember, real property held primarily for resale doesn’t qualify for 1031 tax deferral.
The recommendation is to hold your replacement property for at least one year.
