1031 Exchange Basics for Investment Property

A 1031 exchange lets you sell real estate you hold for investment or business use and put off paying tax on the gain, as long as you reinvest in other investment real estate under strict IRS rules. The two rules people trip on: you must identify the replacement property in writing within 45 days of selling, and close on it within 180 days (or by your tax return due date, if that comes first).

It does not work for the home you live in. Here is what qualifies, how the deadlines run, what a qualified intermediary does, and how cash or debt left over (“boot”) gets taxed.

What qualifies, and what doesn't

Since January 1, 2018, section 1031 applies only to real property. The IRS says real property held for business use or investment can be exchanged for other real property held for business use or investment, and real estate is generally like-kind to other real estate whether it is improved or not. A rental townhouse can be exchanged for an apartment building, a store, or land.

If you once lived in the property and later rented it, or you rent out part of a two-family you live in, the IRS points to Revenue Procedure 2005-14 for combining the home sale exclusion with an exchange. This is a case for a tax professional.

What about a NYC co-op?

A co-op apartment is technically shares of stock plus a proprietary lease, and stock normally can't be exchanged. However, the Form 8824 instructions say that Treasury regulations list stock in a cooperative housing corporation as real property for section 1031 purposes. So co-op shares can be part of an exchange, but only if the other rules are met too. Whether yours qualifies depends on facts:

• You must actually hold the co-op for investment or business use, typically as a rental. A pied-à-terre or vacation home is a harder case.
• Many co-ops limit or forbid subletting, which can make holding one as an investment impractical. See co-op sublet rules.
• A co-op buyer needs board approval, which can blow through the 180-day window. Plan for it.

Get a tax adviser to confirm before you rely on a co-op in an exchange.

The 45-day and 180-day deadlines

Both clocks start the day you transfer the property you are giving up, and they run at the same time: the 45 days are part of the 180, not added to them.

1. Day 0

   You close on the property you’re selling

   Sale proceeds go to the qualified intermediary, not to you.

2. By day 45

   Identify the replacement in writing

   A signed document sent to the intermediary or another required party, with a legal description, street address or distinguishable name. If you close on a replacement before day 45, it counts as identified.

3. Days 46–180

   Close on one or more identified properties

   You can only buy what you identified.

4. By day 180 or your return due date

   Exchange must be complete

   Whichever comes first. If you sell late in the year, file an extension so the return due date doesn’t cut your 180 days short.

Get exact dates for your sale with the 1031 exchange deadline calculator.

How many properties you can identify

Pub. 544 sets limits. You can identify either:

• up to three properties of any value, or
• any number of properties whose total value is no more than 200% of the value of what you sold.

If you identify more than that, only properties you actually receive count, and only if what you receive is at least 95% of the value of everything you identified.

The qualified intermediary

If the sale money touches your hands, even briefly, the exchange can fail. The standard safe harbor is a qualified intermediary (QI): a company that signs an exchange agreement with you, receives the sale proceeds, and uses them to buy the replacement. Your agent (such as your attorney or broker who has worked for you) and related parties are “disqualified persons” who can't serve as the QI.

1. 1

   Hire the QI before the sale closes

   The exchange agreement and assignment must be in place at or before closing. You can’t set it up after you have the money.
2. 2

   Proceeds go to the QI

   Your closing statement should show the net proceeds wired to the intermediary.
3. 3

   Identify within 45 days

   Send the signed identification as your exchange agreement directs.
4. 4

   QI funds the purchase

   The intermediary wires the money to close on the replacement within the exchange period.

Boot: when part of the gain is taxed now

You can defer all the gain only if you reinvest all the net proceeds and replace the debt you paid off. Anything else you receive, such as cash, other property, or a net reduction in your mortgage, is boot. You recognize gain up to the amount of boot. You can't deduct a loss on an exchange.

Deferred gain carries over into the new property through a lower basis, so it is taxed later if you sell without another exchange. Depreciation you took also matters; see the depreciation recapture calculator.

Related-party exchanges

If you exchange with a relative or a related company, and either of you disposes of the property received within two years, the deferred gain generally becomes taxable that year. Related parties include your spouse, children, grandchildren, parents, grandparents and siblings, and certain related entities. There are exceptions for death, involuntary conversions and transactions without a tax-avoidance purpose.

New York at the closing table

New York starts from your federal income, so a valid federal exchange generally defers the New York tax too. For a New York nonresident selling New York property, the state's estimated-tax form (IT-2663 for real property, IT-2664 for co-op shares) tells you to skip the estimated tax calculation when no gain is recognized under the Internal Revenue Code, and instead mark that reason on the form, which is filed when the deed is recorded. If you receive boot, some gain is recognized, so that exemption box doesn't fit; the form's worksheet asks for the gain you will report on your federal return. See the nonresident seller estimated tax calculator.

Transfer taxes are a separate matter. A 1031 exchange does not exempt you from NYC or New York State transfer taxes on either the sale or the purchase.