April 01, 2025 | by Atherton & Associates, LLP
If you’re thinking about selling investment real estate, you’ve probably heard someone say, “Just do a 1031 exchange—you won’t pay any tax.” That’s partially accurate but also an oversimplification.
The IRS does allow you to defer capital gains taxes on the sale of certain property, but the rules around Section 1031 exchanges are a bit more nuanced than most people realize. And getting it wrong—especially on what qualifies—can result in unexpected tax liability.
What is a 1031 exchange?
In short, a 1031 exchange lets you sell one piece of investment or business-use real estate and defer the capital gains taxes by rolling the proceeds into another qualifying property. It’s named after Section 1031 of the Internal Revenue Code, and it’s been around in some form for over 100 years.
The key concept here is “like-kind.” You’re exchanging one like-kind property for another.
Importantly, the IRS requires that a third-party intermediary facilitate the exchange process. This entity is called a qualified intermediary (QI), and it plays a role in nearly all exchanges.
What types of property qualify?
Under current law, only real property qualifies for a 1031 exchange. That’s a change from pre-2018 rules—before then, certain personal property (like equipment or aircraft) could be exchanged, too. The Tax Cuts and Jobs Act (TCJA) narrowed it to real estate only (IRC §1031(a)(1)).
Now, eligible real property can include:
- Commercial buildings
- Rental properties (residential or mixed-use)
- Raw land
- Industrial facilities
- Retail centers
- Oil, gas, and mineral interests, in certain circumstances
Even long-term leasehold interests (typically 30 years or more) may qualify in some cases.
It’s also worth noting: the properties don’t have to be the same type. You can exchange raw land for an apartment complex or a strip mall for a warehouse. As long as both are held for investment or business use, the IRS generally treats them as like-kind (Treas. Reg. §1.1031(a)-1(b)).
What doesn’t qualify?
Several categories of property are ineligible for 1031 treatment. These include:
- Property held primarily for resale (think fix-and-flip properties or land held for development and quick turnover)
- Primary residences
- Second homes or vacation homes, unless they meet strict rental and use requirements
- Foreign property (U.S. property must be exchanged for U.S. property only)
Additionally, personal-use items such as vehicles, equipment, or artwork are excluded from eligibility under the current rules, regardless of how they are used in a business context.
Vacation rentals: a common gray area
Vacation homes used for both rental and personal purposes can fall into a gray area. The IRS has provided a safe harbor under Revenue Procedure 2008-16 that allows some vacation rentals to qualify, but strict requirements apply:
- The property must be rented for at least 14 days per year;
- Personal use must be limited to 14 days or 10% of the rental days, whichever is greater;
- The taxpayer must meet these criteria for at least two years before and after the exchange.
If these thresholds aren’t met, the property is unlikely to qualify under 1031 rules.
Timing rules
Even if your properties qualify, the timeline rules are strict:
- You have 45 days from the sale of your relinquished property to identify a replacement property.
- You have 180 days to close on the replacement.
And yes, these timelines run concurrently. Day 180 doesn’t reset after Day 45—it’s all from the date of the first sale.
If either deadline is missed, the exchange fails, and the gain becomes taxable.
Intent matters
Although not explicitly stated in the statute, intent is a critical factor. The IRS and courts often evaluate whether the property was truly acquired for investment or business use.
For instance, if a taxpayer acquires a replacement property and sells it within a few months, the IRS may challenge the exchange based on a lack of investment intent. Similarly, attempting to exchange into a personal residence may raise concerns unless the property is held as a rental for a significant period first.
There’s no statutory holding period, but retaining the replacement property for at least one year is generally considered a prudent guideline.
The role of the qualified intermediary
Many taxpayers are surprised to learn that they cannot take direct possession of the sale proceeds in a 1031 exchange—not even temporarily. If you receive the funds, even for a day, the IRS considers the exchange invalid, and the gain becomes taxable.
That’s where the qualified intermediary comes in.
A QI—sometimes referred to as an exchange accommodator or facilitator—holds the proceeds from the sale of your relinquished property in escrow until they are used to purchase the replacement property. The QI may also prepare the necessary exchange documentation, ensure compliance with IRS regulations, and help manage the strict timeline requirements.
Why is a QI necessary?
Because IRS rules explicitly prohibit the taxpayer from having constructive receipt of the funds. Even if you never deposit the check, routing the proceeds through your own attorney or escrow agent can disqualify the exchange if not structured properly.
Clients often ask why this intermediary is necessary and why it comes with an out-of-pocket cost. The reality is that the QI is not just a formality—it’s a critical safeguard in keeping the exchange compliant. While fees vary, the cost is generally modest relative to the tax deferral benefit.
Advanced exchange options
Sometimes, your situation just doesn’t line up neatly with the typical 1031 exchange timeline or structure. Fortunately, there are more flexible options—but they come with extra complexity.
Reverse exchanges: buy first, sell later
In a standard exchange, the relinquished property is sold first. But what happens if you identify the ideal replacement property before you’ve finalized the sale?
That’s where a reverse exchange becomes useful. In this structure, a qualified intermediary—through an Exchange Accommodation Titleholder (EAT)—temporarily holds title to either the relinquished or replacement property during the transaction.
The 45-day and 180-day deadlines still apply, but in reverse sequence. This allows more flexibility in timing, but adds cost and complexity. Financing can also be more challenging, since the EAT holds legal title to the property during part of the exchange process.
Still, it’s a valuable tool when market timing doesn’t cooperate.
Build-to-suit exchanges: customize your replacement property
If the replacement property requires significant renovation—or if you intend to build on undeveloped land—you might consider a build-to-suit exchange, also known as an improvement exchange.
This structure allows exchange proceeds to be used for construction or renovation before the taxpayer takes legal title. Again, the intermediary (via an EAT) holds title during the build-out phase.
However, all improvements must be completed within the 180-day exchange window, and ownership must be formally transferred to the taxpayer within that period. If improvements are incomplete, only the value of what’s been completed by day 180 can be counted toward deferral.
These exchanges take careful planning and close coordination between your CPA, your intermediary, and your builder.
Laddering exchanges: long-term planning for real estate investors
Many experienced investors use laddering as a long-term strategy. Essentially, you start with one property, exchange into a larger or better-performing one, then do it again. And again. Each time, you defer the gain and build more equity.
Eventually, you may decide to cash out and recognize the gain (hopefully in a lower-tax year). Or, you may hold the final property until death—in which case your heirs get a step-up in basis, and the deferred gain essentially disappears.
It’s a long-game strategy, but it’s one that many successful investors use to build wealth and reduce taxes along the way.
A 1031 exchange can be a powerful tax strategy—if you get the details right
A well-structured exchange can preserve capital and open the door to better investment opportunities. But it’s not a DIY strategy. The rules around property type, timing, and use all require careful execution.
If you’re considering a sale or contemplating a new investment, we strongly recommend discussing your options with a tax advisor early in the process. We can help you weigh your options, identify potential roadblocks, and structure the exchange in a way that actually works.
For personalized guidance, please contact our office.
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