design-1031-exchange-plan

Design 1031 Exchange Plan

Use a Section 1031 like-kind exchange to defer capital gains and depreciation recapture taxes when selling an investment property and reinvesting in another.

Why This Is Best Practice

Adopted by: Section 1031 has been in the Internal Revenue Code since 1921 — over 100 years as a foundational real estate wealth-building tool. Commercial real estate investors, REITs, and family offices use 1031 exchanges systematically on every sale to compound wealth tax-deferred. According to the National Association of Realtors, 1031 exchanges facilitate approximately $100B in commercial transactions annually. Every real estate attorney and CPA practicing real estate tax uses this as a primary planning tool. Impact: On a $1M property with $400k gain (40% appreciation), a straight sale at 23.8% capital gains + depreciation recapture could trigger $95,000+ in taxes — capital that could instead be reinvested into a larger property. Over 20 years of compounded tax-deferred growth, each 1031 exchange generates substantially more wealth than paying tax and reinvesting the remainder. Some real estate families defer taxes for decades across generations, and under current law, heirs receive a stepped-up basis at death — permanently eliminating the deferred liability. Why best: The 1031 exchange is the only mechanism allowing full reinvestment of gross proceeds (pre-tax) into a new property. Every dollar not paid in taxes continues compounding at the property's return rate. For a serial real estate investor, this is the highest-impact legal tax strategy available — more impactful than depreciation, cost segregation, or any other real estate tax tool.

Steps

1. Confirm eligibility — The sold ("relinquished") and purchased ("replacement") properties must:

   • Be held for productive use in a trade/business or for investment (NOT personal residence, fix-and-flip inventory, or dealer property)
   • Be "like-kind" — in practice, any US real property qualifies (residential for commercial, land for apartment building, etc.)
   • Both be located in the United States (foreign property cannot 1031 exchange with US property)

2. Engage a Qualified Intermediary (QI) BEFORE closing — The QI is legally required; you cannot touch the sale proceeds yourself. The QI holds funds between transactions. Critical: the QI must be engaged before the relinquished property closes — retroactive QI engagement is not allowed. QI fees typically $750–$2,000 for a single exchange.

3. Close the relinquished property — The QI receives sale proceeds directly at closing. You never receive or have constructive receipt of the funds. The exchange clock starts the day the relinquished property closes.

4. Identify replacement property within 45 days — You have exactly 45 calendar days from the relinquished property closing to identify potential replacement properties in writing to the QI. No extensions, no exceptions (unless presidentially declared disaster). Three identification rules (choose one):

   • 3-Property Rule (most common): identify up to 3 properties of any value
   • 200% Rule: identify any number of properties, but total fair market value ≤ 200% of relinquished property value
   • 95% Rule: identify any number of properties but must close on at least 95% of identified value — rarely used

5. Close replacement property within 180 days — You must close on one or more identified replacement properties within 180 calendar days of the relinquished property closing (NOT 180 days from identification — 180 days from the original sale). The 45-day identification deadline falls within this 180-day window.

6. Meet the "equal or up" requirements — To fully defer all taxes:

   • Replacement property price ≥ relinquished property net sale price (not gross — net of commissions and closing costs)
   • Equity reinvested ≥ equity from relinquished property (no "boot" extracted)
   • Debt assumed ≥ debt released (or make up difference with additional cash) If any requirement is partially missed, you pay tax on the "boot" (value received) but still defer on the rest.

7. Calculate deferred gain and new basis — Your basis in the replacement property carries over (adjusted downward). Deferred gain doesn't disappear — it's embedded in lower basis of the new property, which means higher future gain or depreciation recapture unless you exchange again or step up at death. New basis = replacement property price − deferred gain + boot paid.

8. File IRS Form 8824 — Report the like-kind exchange on your tax return for the year of the exchange. Attach to Schedule E. Report both properties, timeline, QI details, and deferred gain calculation.

Rules

• Never touch the proceeds — any constructive receipt (proceeds in your account, even briefly) disqualifies the exchange. Engage a QI before closing.
• The 45-day identification deadline is absolute — if you miss it by one day, the exchange fails and the full gain is taxable in that year.
• Identify conservatively — if you identify 3 properties and all fall through, the exchange fails. Include realistic backup options.
• Boot is taxable — if you extract cash ("cash boot") or receive net debt relief ("mortgage boot"), that portion is taxable even in a successful 1031. Plan to be "equal or up" on both equity and debt.
• 1031 applies only to investment property — converting a property to personal use shortly after exchange triggers IRS scrutiny; the safe harbor is 2 years of investment use.

Examples

Residential rental → commercial apartment: Sell: 4-unit rental for $800k net (originally purchased for $400k; $80k depreciation taken → adjusted basis $320k). Gain: $480k. Potential tax: $114k+ (capital gains + depreciation recapture). 1031: QI holds $800k. Within 45 days: identify a 20-unit apartment building at $1.2M. Within 180 days: close. Borrow $400k to make up difference. Equity invested: $800k. Debt: $400k. Result: $114k tax deferred. Full $800k compounding in new property. New basis: $720k ($1.2M − $480k deferred gain). Future depreciation calculated on $720k basis, not $1.2M.

Partial exchange (boot): Sell for $600k net, carry $200k mortgage. Replace with $550k property. Boot = $50k shortfall in price + mortgage released is net $200k relief. Tax owed on $250k of boot; remainder deferred.

Common Mistakes

• Starting the exchange after closing — the QI must be engaged and the exchange agreement signed BEFORE the relinquished property closes. Post-closing QI engagement invalidates the exchange.
• Missing the 45-day deadline — investors who cannot identify replacement properties within 45 days lose the exchange entirely. In a tight market, identify backup properties even if they're not preferred.
• Extracting cash at closing — sellers who take "net proceeds for closing costs" from the QI have constructive receipt; the IRS will disqualify the exchange. All proceeds flow through the QI without exception.

Finance disclaimer: This skill encodes professional best practices for educational purposes. It is not financial advice. Consult a licensed financial advisor before making investment decisions.