1. What Is a 1031 Exchange?
Named after Section 1031 of the Internal Revenue Code, a 1031 exchange (also called a "like-kind exchange" or "Starker exchange") allows you to sell an investment property and reinvest the proceeds into a new property while deferring capital gains tax.
The Core Idea
The IRS views it this way: if your economic position hasn't really changed—you're just swapping one investment property for another—it would be unfair to tax you and deplete your reinvestment capital. So they let you defer the tax.
Key word: defer. This is not a tax exemption. The tax is postponed until you eventually sell a property without doing another exchange. But the strategy is powerful:
- You can do unlimited 1031 exchanges throughout your life
- Each time, you defer the accumulated gains
- If you hold until death, your heirs get a "stepped-up basis" to fair market value
- The stepped-up basis can eliminate all the deferred gains
2. What Properties Qualify?
Not every property qualifies. You must pass two tests: the Qualified Use test and the Like-Kind test.
The Qualified Use Test
Both the property you're selling (the "relinquished property") and the property you're buying (the "replacement property") must be held for:
- Investment (e.g., rental property, land held for appreciation)
- Business use (e.g., office building, warehouse)
| Property Type | Qualifies? | Why |
|---|---|---|
| Rental property | ✓ Yes | Held for investment |
| Raw land | ✓ Yes | Held for appreciation or future business |
| Commercial building | ✓ Yes | Business use |
| Primary residence | ✗ No | Personal use (see Section 121 instead) |
| Vacation home (personal use) | ✗ No | Personal use |
| Fix-and-flip | ✗ No | Held for sale = inventory, not investment |
| Vacation rental (Airbnb) | Maybe | Must meet IRS safe harbor rules |
The Like-Kind Test (It's Broader Than You Think)
"Like-kind" sounds restrictive, but it's actually very broad for real estate. It refers to the nature or character of the property, not its specific type.
Bottom line: Almost any U.S. real property held for investment is like-kind to any other U.S. real property held for investment.
| Selling | Buying | Like-Kind? |
|---|---|---|
| Apartment building | Industrial warehouse | ✓ Yes |
| Single-family rental | Raw land | ✓ Yes |
| Retail strip center | Multi-family apartment | ✓ Yes |
| U.S. property | Foreign property | ✗ No |
| Real estate | Stocks, bonds, etc. | ✗ No |
3. The Critical Timelines
The 1031 exchange has two strict, non-extendable deadlines. Miss either one and the entire exchange fails—your gain becomes fully taxable.
Sale Closes
You sell your property. Funds go directly to the Qualified Intermediary (QI)—never to you.
Identification Deadline
You must provide a signed, written list of potential replacement properties to your QI. No exceptions.
Exchange Deadline
You must close on one or more of the identified properties. The clock started on Day 0.
The Identification Rules
On Day 45, you must identify potential replacement properties in writing. You have three options:
The 3-Property Rule (Most Common)
Identify up to 3 properties of any value. You can close on one, two, or all three.
The 200% Rule
Identify any number of properties, as long as their total value doesn't exceed 200% of what you sold for.
The 95% Rule
Identify unlimited properties of any value, but you must actually acquire 95% of the total identified value.
Most investors use the 3-Property Rule. It's simple and gives you backups if one deal falls through.
4. The Qualified Intermediary (QI)
The biggest trap in a 1031 exchange: you can never touch the money. If the sale proceeds hit your bank account—even for a moment—the exchange is dead, and you owe tax on the entire gain.
This is called "constructive receipt." To avoid it, you use a Qualified Intermediary (QI)—a neutral third party who holds the funds for you.
What the QI Does
- Takes an assignment of your rights in both the sale and purchase contracts
- Receives the sale proceeds directly from the title company
- Holds the funds in a segregated escrow account
- Prepares the legal exchange documents
- Transfers funds directly to the seller when you close on the replacement property
QI Safety
Your QI will hold potentially millions of dollars. Choose carefully:
- Ask about errors & omissions insurance and fidelity bonding
- Ensure funds are held in a segregated, FDIC-insured account
- Use established companies with track records
- Typical fees: $750 – $1,500 per exchange
5. Understanding Boot (With Examples)
"Boot" is anything you receive in the exchange that isn't like-kind real estate. Boot is taxable—immediately.
There are two types of boot, and understanding them is crucial to a successful exchange.
Type 1: Cash Boot
If you don't reinvest all of the sale proceeds, the leftover cash is "cash boot."
Cash Boot Example
You sell a rental for: $500,000
You buy a replacement for: $450,000
Cash you kept: $50,000
Result: The $50,000 is cash boot. You owe capital gains tax on $50,000 (or your actual gain, whichever is less).
Type 2: Mortgage Boot (Debt Relief)
This one surprises many investors. If the mortgage on your replacement property is less than the mortgage you paid off, the difference is "mortgage boot"— even if you never see a dollar of cash.
The IRS views it this way: you had $400,000 of debt, now you only have $300,000. That $100,000 reduction in liability is a benefit to you—and it's taxable.
Mortgage Boot Example
Old property mortgage payoff: $400,000
New property mortgage: $300,000
Debt reduction: $100,000
Result: The $100,000 debt reduction is mortgage boot. You owe tax on it.
Complete Boot Calculation Example
Let's walk through a full example with both types of boot:
Full Boot Calculation
| Item | Old Property | New Property | Difference |
|---|---|---|---|
| Sale/Purchase Price | $1,000,000 | $950,000 | $50,000 (cash boot) |
| Mortgage | $400,000 | $350,000 | $50,000 (mortgage boot) |
| Total Taxable Boot | $100,000 | ||
Even though the investor successfully deferred most of the gain, they'll owe capital gains tax on $100,000 of boot.
The Golden Rule: Equal or Greater
To defer 100% of your gain and pay zero tax, follow this rule:
- Replacement property price ≥ Sale price of old property
- Replacement mortgage ≥ Old mortgage payoff
- Reinvest 100% of the net proceeds
6. Types of Exchanges
Delayed Exchange (Standard)
The most common type. You sell first, then buy within 180 days. This is what most investors do.
Simultaneous Exchange
Both properties close on the same day. Rare because coordinating two closings is logistically difficult, but it eliminates timeline risk.
Reverse Exchange
You buy the replacement property before selling your old one. Useful in competitive markets where you can't wait to find a buyer.
How it works: An "Exchange Accommodation Titleholder" (EAT) temporarily holds either the new or old property. You then have 180 days to complete the exchange.
Improvement/Construction Exchange
You use sale proceeds to both acquire and improve the replacement property. Improvements must be completed within the 180-day window to count toward the exchange value.
7. Delaware Statutory Trusts (DSTs)
Delaware Statutory Trusts (DSTs) are a powerful backup option—and increasingly, a primary strategy—for 1031 exchangers.
What Is a DST?
A DST is a legal entity that owns institutional-grade real estate (think: large apartment complexes, medical buildings, shopping centers) and sells fractional "beneficial interests" to investors.
Under IRS Revenue Ruling 2004-86, these interests are treated as direct real estate ownership— meaning they qualify for 1031 exchanges. This makes DSTs popular with accidental landlords and tired landlords looking to exit active management while preserving tax deferral.
Why DSTs Are Popular
| Feature | Direct Ownership | DST |
|---|---|---|
| Management | Active (you're the landlord) | Passive (professional sponsor) |
| Closing Speed | Weeks to months | 3-5 days |
| Minimum Investment | Full property price | $100K-$250K typical |
| Diversification | Single asset | Multiple properties possible |
| Financing | Personal/recourse loans | Non-recourse (institutional) |
The DST as a 'Backup Plan'
The 45-day identification deadline creates enormous pressure. What if your deal falls through? What if you can't find the right property?
DSTs solve this because they're "pre-packaged"—the property is already acquired, the financing is in place, and you can close in days, not weeks. Many investors identify a DST as one of their three properties under the 3-Property Rule, just in case.
DST Considerations
- Illiquid—you're locked in for the life of the investment (typically 5-10 years)
- No control over property decisions
- Fees can be higher than direct ownership
- Must work with a broker-dealer to invest
8. Basis Carryover & Depreciation
A crucial but often overlooked aspect: in a 1031 exchange, your basis carries over. The replacement property doesn't start with a fresh basis equal to its purchase price.
What This Means
Your new property's basis = your old property's adjusted basis (plus any boot paid, minus any boot received, plus any gain recognized). This affects your depreciation deductions and future gain calculations. See our Investment Metrics Guide for how basis impacts returns.
Basis Carryover Example
Old property adjusted basis: $200,000
Sale price: $500,000
New property purchase price: $600,000
Cash added: $100,000
New property basis: $200,000 (old basis) + $100,000 (cash added) = $300,000
Even though you paid $600,000, your tax basis is only $300,000. The $300,000 of deferred gain is "built into" the new property.
Depreciation Recapture
When you do a 1031 exchange, depreciation recapture is also deferred. But it doesn't disappear— it accumulates and will be due when you finally sell without exchanging. See our Tax Guide for more on how depreciation works.
Depreciation recapture is taxed at 25% (Section 1250 gain), higher than the long-term capital gains rate. After multiple exchanges over decades, this can become a significant sum.
The solution? The "swap 'til you drop" strategy. Upon death, heirs receive a stepped-up basis, and the accumulated depreciation recapture may be eliminated.
9. Common Pitfalls
Missing the 45-day deadline
The most common failure. Set calendar reminders and have backup properties ready.
Touching the money
If proceeds go to your account—even temporarily—the exchange fails. Always use a QI.
Forgetting mortgage boot
Reducing your debt is taxable boot. Many investors forget this and get surprised.
Engaging a QI too late
Your QI must be in place before closing. Engage them before you even list your property.
Vague property identification
Your 45-day identification must be unambiguous—street address or legal description. "A property in Miami" won't work.
Related party transactions
Exchanges with family members or controlled entities have special rules and holding requirements. Get tax advice.
10. Key Takeaways
- "Swap 'til you drop"—keep exchanging throughout your lifetime. Upon death, heirs receive a stepped-up basis, potentially eliminating all deferred capital gains and depreciation recapture
- 45 days to identify, 180 days to close—these deadlines are absolute and cannot be extended
- Never touch the money—use a Qualified Intermediary (QI) or the exchange fails
- Boot = tax—any cash you keep or debt you reduce is immediately taxable
- DSTs as backup—Delaware Statutory Trusts close in days and let you match exact amounts to avoid boot