1031 Exchanges: Key Tax Rules and Requirements

Posted on June 30, 2025

A 1031 exchange allows taxpayers to defer capital gains tax on the sale of investment or business-use real property by reinvesting the proceeds into another qualifying piece of real property. This is governed by Section 1031 of the Internal Revenue Code. This memo will discuss the key tax rules and requirements associated with 1031 exchanges. 

What Qualifies

To qualify for a 1031 exchange, both the property being sold and the property being acquired must be real estate held for investment or business purposes. This includes commercial buildings, rental properties, raw land, industrial facilities, retail centers, and certain mineral interests. The properties do not have to be the same type; for example, you can exchange raw land for an apartment building as long as both are held for investment or business use. However, properties held primarily for resale (such as fix-and-flip projects), primary residences, second homes, foreign property, and personal-use assets like vehicles or artwork do not qualify.

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 are not met, the property is unlikely to qualify under the 1031 rules.

Timing, Intent and Qualified Intermediaries

Strict timelines apply to 1031 exchanges. After selling the relinquished property, you have 45 days to identify potential replacement properties and 180 days to complete the purchase of the replacement property. These periods run concurrently, and missing either deadline will disqualify the exchange, making the gain taxable.

Note, if in a 1031 exchange the taxpayer reinvests the proceeds into a replacement property of lesser value than the relinquished property, any portion of the sale proceeds not reinvested—commonly referred to as “boot”—will be subject to immediate gain recognition and taxed accordingly.

Intent also matters in a 1031 exchange. The IRS expects that both the relinquished and replacement properties are genuinely held for investment or business use. 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. While there is no statutory minimum holding period, retaining the replacement property for at least one year is generally recommended to demonstrate investment intent.

Another critical requirement is the use of a qualified intermediary (QI). The investor cannot take possession of the sale proceeds at any point. Instead, a QI holds the funds in escrow and facilitates the exchange. If the investor receives or controls the funds, even briefly, the IRS will consider the exchange invalid, and the gain will become taxable.

Section 1031 Variations

There are advanced variations of 1031 exchanges for more complex situations. A reverse exchange allows you to acquire a replacement property before selling the relinquished property, with the QI temporarily holding title. A build-to-suit exchange lets you use exchange proceeds for improvements or new construction on the replacement property, but all work must be completed within the 180-day window. Some investors use a strategy called “laddering,” where they repeatedly exchange into larger or better-performing properties, deferring taxes over many years or even until death, at which point heirs may receive a step-up in basis.

Conclusion

A Section 1031 exchange is a valuable tool for real estate investors to defer taxes and build wealth, but it requires careful adherence to IRS rules regarding property type, timelines, and use of a qualified intermediary. Missteps can lead to immediate tax liability, so it is important to consult with your Topel Forman advisor as soon as possible if considering a Section 1031 exchange.