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IRC Section §1031 Exchange Rules and Timelines

IRC Section §1031

“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”

When a business or investment property is sold for a gain, typically one must pay tax on the gain at the time of sale.  IRC Section 1031 provides an exception that allows postponement of recognition of the gain if proceeds are reinvested in similar property as part of a qualifying like-kind exchange.  Ultimately, the gain deferred can be permenanetly emilminated with a step up in cost basis to beneficiaries.

Meet Arthur and Linda Blank, Investment Real Estate Owners

Arthur and Linda have owned a multifamily property in the state of California for the past 20 years which has appreciated significantly and provided stable monthly income.

They are both turning 65 next year and would like to eliminate all real estate management responsibilities.  Since their property has appreciated in value they feel now is a good time to sell.

Their objective is to maintain the income they have been accustomed to and leave as much assets as possible to their daughter Jane upon their passing.

A friend has told them that a 1031 exchange could help defer taxes and allow them to keep their full equity base intact to maximize future income.  They would like to learn more.

Option 1 - Taxable Transaction

Sell the property, pay the taxes and use the proceeds to invest in another income producing asset

Upon sale of the property Arthur and Linda would be subject to sizable taxes on their capital gain

Taxation on sales proceeds would diminish the equity base used to generate future income.

Potential Taxes

  • Federal Capital Gains Tax

  • State Tax

  • Depreciation Recapture Tax

  • Net Investment Income Tax


Option 2 - 1031 Exchange

The Qualified Intermediary (QI); also known as an exchange facilitator; maintains cash proceeds in an escrow account and helps to ensure that all 1031 requirements are met

Professional Female

Upon the sale of the property, Arthur and Linda would have the proceeds of the relinquished property sent directly to a Qualified Intermediary.  The clock starts ticking!

Minimizing Taxes While Maximizing Income

Hypothetical Illustration

The illustration below highlights the potential benefits of tax deferral through a 1031 exchange.  Assumptions include:


Arthur and Linda sell their relinquished property for a sale price of $2.0 m.  Their cost basis was $600,000, thus exposing them to roughly $1.27 m of potential capital gains after closing costs.  Because they had depreciated their property over the 20 years, they would have to recapture that depreciation at a flat 25% tax rate.  With an assumed capital gains tax rate of 20%, state tax rate of 13.3% as well as a 3.8% net investment tax, Arthur and Linda would lose an estimated 31% of their proceeds to taxes.

Since their objective is to maximize income, the best way to do that is by conducting a 1031 exchange and using the gross proceeds rather than net after tax remainder equity.  The difference in income can be substantial, and ultimately they can leave the assets to their daughter Jane to permanently elimate taxes through a step-up in cost basis.

Mother and Daughter
1031 Exchange Process & Timelines

Property Sold

45 Days to identify replacement property

180 Days to close escrow on replacement property



Professional Female

The QI officially records the date and time of property identification prior to midnight on the 45th day

The QI uses the proceeds from the relinquished property to close escrow on the replacement property prior to midnight on the 180th day

Role of the QI

Properties must be "like Kind".  Generally, any real estate held within the United States for business or investment purposes is considered like-kind regardless of type, grade or quality.



Identification Rules and Tax Optimization

Property Identification Rules

When identifying replacement property an investor can utilize one of the following rules:

3 Property Rule - Identify up to three potential replacement properties and purchase any (or all) of them, regardless of their total value, to complete the exchange

200% Rule - Identify more than three potential replacement properties if their combined total value does not exceed 200% of the value of the relinquished property.  Purchase as many of the identified properties as one wants.

95% Rule - Identify any number of potential replacement properties regardless of their value as long as at least 95% of the total value of all of the properties identified are purchased

Door Handle

To Defer Taxes Fully

  ○  All proceeds from the sale of a relinquished property must be reinvested in replacement property

  ○  An investor must assume an equal or greater amount of debt than that which was held on he relinquished property or add additional equity to offset a reduction in debt

  ○  The title on the replacement property must be identical to that of the relinquished property

These are just a few of the considerations when conducting a 1031 exchange.  Please consult your Tax Advisor and Qualified Intermediary for more information regarding IRC Section 1031 exchange rules and regulations.

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