A like-kind exchange under Section 1031 lets you sell investment or business real estate and defer the capital gains tax, including depreciation recapture, by reinvesting in other real estate. Done correctly, it is one of the most effective tools for building a real estate portfolio. Done incorrectly, it becomes a fully taxable sale. Most of the problems we see can be avoided with planning before the contract of sale is signed.
What qualifies
- Both properties must be real property held for investment or used in a trade or business. Since 2018, only real property qualifies; equipment and other personal property no longer do.
- “Like-kind” is broad for real estate. You can exchange an apartment building for raw land, a warehouse or a net-leased retail property.
- Your primary residence does not qualify, and neither does property held mainly for resale, such as a developer’s or flipper’s inventory.
- The taxpayer that sells must be the taxpayer that buys. If an LLC sells the property, that same LLC generally must acquire the replacement.
Two deadlines that won’t move
- 45 days to identify. From the day you transfer the property you’re selling, you have 45 calendar days to identify replacement property in writing. Most investors use the three-property rule, which lets you identify up to three properties of any value.
- 180 days to close. You must acquire the replacement property within 180 days of the sale, or by the due date of your tax return for that year if that comes first. A sale late in the year can lose part of its 180 days unless you extend your return.
Weekends and holidays count, and ordinary delays don’t extend either deadline; only relief for federally declared disasters does. The 1031 deadline calculator on our homepage shows both dates for any sale.
Engage a qualified intermediary before you close
You cannot have access to the sale proceeds. If the money is paid to you, even briefly, the exchange fails. A qualified intermediary must be engaged, and the exchange documents signed, before the sale closes so the proceeds go directly to the intermediary. Your attorney, real estate broker or anyone who has acted as your agent in the past two years generally can’t serve in that role.
Avoid taxable “boot”
To defer all of the gain, you generally need to:
- buy replacement property of equal or greater value than the property you sold;
- reinvest all of the net cash proceeds; and
- replace any mortgage paid off at the sale with new debt or additional cash.
Cash you keep, or debt that isn’t replaced, is called boot. It is taxable even when the rest of the exchange qualifies.
New York issues to plan for
- Income tax generally follows federal. New York State and New York City generally follow the federal treatment, so a valid exchange also defers state and city income tax on the gain.
- Transfer taxes are not deferred. New York State and New York City real estate transfer taxes, and the “mansion tax” on certain residential purchases, are due at closing whether or not the sale is part of an exchange.
- Nonresident sellers. If you live outside New York and sell New York property, the state requires an estimated tax filing at closing. An exchange can change what is owed, so coordinate that filing with your attorney and intermediary in advance.
Partnerships and co-owners
Exchanges get complicated when a partnership or LLC owns the property and the partners want different outcomes, with some wanting to exchange and others wanting to cash out. Restructuring ownership shortly before a sale, sometimes called a “drop and swap,” can be challenged by the IRS. It needs planning well before the property is listed.
Before you list the property
Talk with your CPA before you sign a contract of sale. We estimate the tax being deferred, confirm the entity and debt structure work, coordinate with your attorney and intermediary, and track the deadlines through closing. Learn more about our real estate practice.
This article is general information, not tax or legal advice. Tax rules change, and how they apply depends on your facts. Consult your advisor before acting.