What is a 1031 exchange in real estate?

JPMorgan Chase & Co., its affiliates, and employees do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for tax, legal and accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any financial transaction.

Quick insights

• A 1031 exchange lets you defer taxes on property sales by reinvesting in similar properties, allowing you to grow your portfolios without losing capital to taxes.
• To qualify, the properties involved must be “like-kind” and follow strict timelines: 45 days to identify the replacement property and 180 days to close.
• Successful 1031 exchanges can involve various property types such as residential, commercial or vacant land, but not personal property.

A 1031 exchange allows you to defer paying capital gains taxes on an investment property sale by reinvesting the proceeds into a similar property. This provision, from Section 1031 of the U.S. Internal Revenue Code, helps investors defer tax liability, allowing them to grow their portfolios without losing money to taxes. For example, if you sell a rental property for a profit and buy another similar property, you can defer the tax on that profit, keeping more of your capital for reinvestment.

How does a 1031 exchange work? Rules and timelines

To qualify for a 1031 exchange, there are specific steps you must follow to ensure the transaction meets IRS requirements. Let’s say you sell a rental property worth $500,000, which has appreciated in value by $200,000. By using a 1031 exchange, you can defer $40,000 in capital gains taxes (assuming a 20% tax rate) and reinvest the full $500,000 into another property, such as a $600,000 commercial building. This allows you to leverage your equity and continue to build your portfolio. 

Initial steps

• Hire a Qualified Intermediary (QI) to manage the exchange (you cannot handle the funds directly). A QI holds the proceeds from the sale of your property to ensure you don’t receive them directly, which would disqualify the exchange.
• The QI will handle most of the paperwork, including filing the necessary IRS forms (such as Form 8824) to report the exchange. QIs can handle the logistics and legalities, giving you peace of mind and helping you legally defer taxes on your property exchange.
• Ensure that all transactions are properly documented, including the sales agreement for the relinquished property and the purchase agreement for the replacement property. 
• Keep detailed records of your property valuations, identification of replacement properties and timelines to avoid any compliance issues.

Chase will not issue Form 1098 or report to the IRS if the mortgagor is a nonindividual. This may limit their ability to deduct the mortgage interest they have paid.

Critical timelines and restrictions

• You have 45 days from the sale to identify potential replacement properties.
• You must complete the purchase of the new property within 180 days of selling the original property.

Like-kind property and non-qualifying properties

• The properties involved must be “like-kind,” meaning they are of the same type (that is, real estate for real estate), but not necessarily the same value or quality.
• This includes residential rental properties, commercial buildings, shopping centers, vacant land, industrial properties and agricultural land.
• Personal property, such as vehicles, art or equipment, is also excluded from 1031 exchanges. Keep in mind that a separate section of the tax code (Section 1033) may apply to some personal property exchanges. Financial instruments like stocks and bonds also usually aren’t eligible for 1031 exchanges.

Tips on identifying suitable replacement properties

• Start early to avoid rushing in the final days of the identification period.
• Use the 3-property rule, which allows you to identify up to three potential properties, regardless of their value.
• Consider the 200% rule, which allows you to identify more than three properties, as long as their combined value does not exceed 200% of the value of the property you sold.

Common pitfalls

• Missing the 45-day identification deadline or the 180-day completion deadline.
• Failing to use a qualified intermediary.
• Not properly following the “like-kind” property requirement.
• Not adhering to strict timing or documentation rules can disqualify the exchange and trigger tax liabilities. 
• If there is a mortgage on your current property, you need to ensure that the debt on your new property is equal to or greater than the original mortgage to avoid “boot” (taxable income).

In summary

A 1031 exchange can be a valuable strategy for deferring taxes and growing wealth by reinvesting in like-kind properties. It aligns well with long-term investment goals, though its future may be influenced by economic shifts and potential tax reforms. To make the most of a 1031 exchange, investors should work with experienced real estate agents, tax advisors and legal counsel. Proper guidance ensures you are compliant while optimizing your returns and minimizing risks.

This article is for informational purposes only. Chase is not providing tax-related advice. For more information, consult a tax professional.