Like-Kind Exchange (1031)
A like-kind exchange, commonly called a 1031 exchange after Section 1031 of the Internal Revenue Code, is a transaction that allows a taxpayer to defer capital gains tax on the sale of real property held for investment or productive use in a trade or business by reinvesting the proceeds into similar qualifying real property within prescribed time limits.
Section 1031 of the Internal Revenue Code allows taxpayers to defer federal income tax on gains from the sale of qualifying property when they exchange it for like-kind property. Before the Tax Cuts and Jobs Act of 2017, like-kind exchange treatment was available for personal property (such as aircraft, artwork, and equipment) as well as real property. The TCJA eliminated like-kind exchange treatment for all property other than real estate, effective January 1, 2018.
For real property, the like-kind requirement is broadly interpreted — any U.S. real property held for investment or business use is considered like-kind to any other U.S. real property held for the same purpose. A single-family rental property can be exchanged for a commercial office building, raw land, or a multifamily apartment complex. The property must not be the taxpayer's primary residence or a vacation home primarily used for personal purposes.
A typical 1031 exchange is a deferred exchange, accomplished through a qualified intermediary (QI). The taxpayer sells the relinquished property, directs proceeds to the QI (who holds them in escrow), identifies potential replacement properties within 45 days, and closes on the replacement property within 180 days of the original sale. Both deadlines are strictly enforced — failure to meet them results in full recognition of the deferred gain.
To achieve complete deferral of all gain, the taxpayer must reinvest all net equity from the sale and acquire replacement property of equal or greater value. If the taxpayer receives cash, debt relief, or other non-like-kind property (collectively called boot), gain is recognized to the extent of the boot received. The remaining gain stays deferred and reduces the basis in the replacement property.
Depreciation recapture under Section 1250 is also deferred in a 1031 exchange — it does not need to be recognized at the time of exchange. However, it carries over to the replacement property and will eventually be recognized when the replacement property is ultimately sold in a taxable transaction.
Upon the death of a taxpayer holding exchanged property, the deferred gain can be eliminated entirely through the step-up in basis at death — a powerful estate planning benefit that motivates some investors to hold 1031-exchanged property until death rather than ever selling in a taxable transaction. Reverse exchanges (acquiring the replacement property before selling the relinquished property) are also permissible under Revenue Procedure 2000-37.