How does a 1031 exchange work? What property managers should know

Amanda Maher
Amanda Maher | 5 min. read
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Published on September 10, 2020

Established real estate investors and property managers are likely already familiar with 1031 exchanges. The concept itself is simple: Reinvest the proceeds from the sale of a business or investment property into a like-kind investment in order to defer paying capital gains tax for you or your owners.

What is a 1031 Exchange?

For those that need a refresher in more detail, Section 1031 is part of the federal tax code. It’s one of the most popular sections in the tax law because it  allows owners of rental property or other business real property to save big.

With a section 1031 exchange, also called a like-kind exchange, again, you can defer paying taxes upon the sale of property by swapping your property for similar property owned by someone else. The property you receive in a like-kind exchange is treated as if it were a continuation of the property you gave up. The result is that you postpone the recognition (taxation) of gain by shifting the basis of old property to the new property. So you defer paying taxes on any profit you would have received and own new property instead.

You can use tax-free exchanges for investment and business real property, but not your personal residence. As a result, landlords can use it for their rental real estate and businesses can use it for office buildings and other business property. Like-kind exchanges can’t be used for personal property like a car—they are limited to real property.

What Exactly is “Like Kind”?

You may only exchange property for other similar property, called like-kind property by the IRS. Like-kind properties have the same nature or character, even if they differ in grade or quality. All real estate owned for investment or business use in the United States is considered to be like kind with all other such real estate in the United States, no matter the type or location. For example, an apartment building in New York is “like kind” to an office building in California.

1031 Exchange Basic Calculations

Say, to start, you buy a property for $300,000 that is worth $500,000 by the time you sell it down the road. Rather than paying capital gains on the $200,000 the house has appreciated, a 1031 exchange would allow you to reinvest the proceeds from the sale into another piece of real estate.

If you keep exchanging your property for property worth at least as much as yours, you’ll never recognize any gain on which you must pay tax. However, sooner or later you’ll probably want to sell the replacement property for cash, not exchange it for another property. Indeed, 88% of real estate replacement properties bought in Section 1031 exchanges are later sold—and taxed. When this occurs, the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax. For this reason, a like-kind exchange is tax deferred, not tax free.

Example: Assume that five years after the exchange described in the above example, you sell your rental property for $800,000 cash. Now you have to pay tax—and quite a lot at that—because you have a $500,000 long-term capital gain. Your gain is $500,000 because your basis in the property is only $300,000 (the basis of the property she exchanged for the building five years earlier). The $800,000 sales price minus the $300,000 basis = $500,000 gain.

Seems simple enough, right? Well, in reality, 1031 exchanges are much more complex. Section 1031 of the Internal Revenue Code (hence the name) has many nuances that can be daunting for first-timers. There are very specific guidelines governing the process. Here’s a brief overview of what you need to know about a typical 1031 exchange process.

The 3 Types of 1031 Exchanges

#1: Deferred or Delayed 1031 Exchange

This is the most common type of 1031 exchange. In this case, the investor closes on the relinquished property; then, within 45 days (the “identification period”), they identify a replacement property. In order for a replacement property to be considered valid, one of three criteria must be true:

Three Property Rule: An investor identifies up to three different properties as potential purchases within the 45-day identification period, regardless of the total fair market value of the properties.

200% Rule: An investor may identify an unlimited number of replacement properties, as long as the total fair market value of all properties does not exceed 200% of the value of the relinquished property.

95% Rule: An investor may identify as many exchange properties as they want, as long as they receive at least 95% of the value of all identified replacement properties before the end of the exchange period.

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In addition to the 45-day identification period, an investor only has 180 days from when they close on the relinquished property to close on the replacement property (the “exchange period”). These two dates are critical for investors to remember.

Pro tip: Because of these time limits, it’s a good idea to have a replacement property lined up before you sell your property. Professional exchange companies (also called accommodators or facilitators) can help you find replacement property and handle the transaction for you.

Finally, this type of 1031 exchange requires investors to use a Qualified Intermediary, also known as an “accommodator.” A QI is an uninvolved third party who holds the investor’s sales proceeds from the sale of their relinquished property in an escrow account until they close on the replacement property. If an investor were to touch the sales proceeds before closing on the replacement property, they would be in violation of Section 1031 and could be held liable for the taxes owed on those proceeds.

Example: You own a rental triplex you bought for $400,000 and is now worth $500,000. You want to exchange it for other property instead of selling it and having to pay tax on his $100,000 profit. You contact Carla, a qualified intermediary. Carla locates a small apartment building worth $500,000 that you like. Bob, the owner of the building, however, has no interest in exchanging it for other property. You and Carla enter into an exchange agreement. Carla purchases Bob’s building for $500,000 cash that he borrows and then exchanges it for your triplex. Carla receives a fee for facilitating the exchange and sells your triplex to repay the funds she borrowed to buy Bob’s property. With Carla’s help, you have exchanged your triplex for Bob’s building, even though Bob didn’t want to do an exchange.

#2: Simultaneous 1031 Exchange

The investor closes on the relinquished property, then closes on the replacement property immediately thereafter—usually within one day. An investor may use a Qualified Intermediary to handle the funds, but they’re not required to.

#3: Reverse 1031 Exchange

The investor acquires a replacement property before conveying the relinquished property to the new buyer.

Still with us? Great! Because we aren’t done just yet…

1031 Exchanges Rules to Keep in Mind

As a general rule of thumb, investors should remember that the replacement property must be of equal or greater value (net of closing costs) than the relinquished property, and all exchange equity must be reinvested for the full tax deferral. To put it simply: trade up, and get no cash out.

In some instances, a 1031 exchange includes the transfer of property that is not considered a like-kind exchange. For example, the sale might include a cash payment to be used toward capital upgrades at the replacement property, which is called a “boot.” Because the cash is not considered like-kind property, the investor may be responsible for paying taxes on the “boot” portion of the exchange.

Meanwhile, a “mortgage boot” is when an investor reduces the mortgage liability on the replacement property below the mortgage liability on their relinquished property. Remember, the replacement property’s debt must be equal to or greater than the sold property’s debt. When a mortgage boot is present, an investor may have to add fresh cash to the transaction to offset the difference.

Phew! That was complicated. But like we said, there are many reasons why an investor might want to consider doing a 1031 exchange. Maybe it’s to avoid paying capital gains taxes right away. Maybe it’s to consolidate several smaller properties into one larger investment. Or maybe, an investor has decided to shift an investment in one area to another locale.

There are countless situations in which a 1031 exchange might be a tax-efficient strategy to preserve your capital. If you’re thinking about using a 1031 exchange, we suggest contacting your tax advisor to discuss the transaction in greater detail.

Read more on Accounting & Taxes
Amanda Maher

Amanda Maher is a self-proclaimed policy wonk who dabbles in real estate law. She holds a B.S. in Political Science and Sociology from Boston University, as well as a master's in Urban and Regional Policy from Northeastern.

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