What Is a 1031 Exchange and How Does It Work?

A 1031 exchange is a tax rule that allows real estate investors to defer capital gains taxes when selling an investment property and reinvesting the proceeds into another qualifying property.

It does not eliminate taxes, but it can delay them, sometimes indefinitely - if done correctly.

This article explains what a 1031 exchange is, who qualifies, and the rules that matter most.

🟢 WHAT A 1031 EXCHANGE DOES

A 1031 exchange allows you to:

🔹 Sell an investment or business property

🔹 Reinvest the proceeds into another qualifying property

🔹 Defer paying capital gains tax on the sale

The key requirement is that the properties involved must be held for investment or business use.

🟢 WHAT TYPES OF PROPERTY QUALIFY

To qualify for a 1031 exchange:

🔹 Both the sold property and the replacement property must be real property

🔹 Both must be held for investment or business purposes

Common qualifying properties include:

🔹 Rental properties

🔹 Commercial buildings

🔹 Land held for investment

Primary residences and personal-use properties do not qualify.

🟢 THE “LIKE-KIND” RULE (SIMPLIFIED)

“Like-kind” does not mean identical.

In simple terms:

🔹 Most real estate is considered like-kind to other real estate

🔹 You can exchange residential for commercial, or land for rental

As long as both properties are real estate held for investment or business use, the like-kind rule is usually met.

🟢 THE STRICT TIMELINES (VERY IMPORTANT)

1031 exchanges are deadline-driven.

There are two critical timelines:

🔹 45-day identification period - You must identify potential replacement properties within 45 days of selling the original property

🔹 180-day exchange period - You must close on the replacement property within 180 days of the sale

Missing either deadline generally disqualifies the exchange.

🟢 WHY A QUALIFIED INTERMEDIARY IS REQUIRED

You cannot receive the sale proceeds directly.

A qualified intermediary (QI):

🔹 Holds the sale proceeds

🔹 Facilitates the exchange

🔹 Ensures funds are handled properly

If you take control of the funds, the exchange usually fails.

🟢 HOW TAX DEFERMENT WORKS

When a 1031 exchange is completed:

🔹 Capital gains tax is deferred

🔹 Depreciation recapture tax is also deferred

🔹 The tax basis carries forward into the new property

Taxes are generally triggered only when the replacement property is sold without another exchange.

🟢 COMMON REASONS INVESTORS USE 1031 EXCHANGES

Investors often use 1031 exchanges to:

🔹 Upgrade to a larger or higher-income property

🔹 Consolidate multiple properties into one

🔹 Diversify into different types of real estate

🔹 Relocate investments geographically

🔹 Continue deferring taxes over time

This can support long-term portfolio growth.

🟢 COMMON MISTAKES TO AVOID

1031 exchanges are technical and unforgiving.

Common issues include:

🔹 Missing the 45-day or 180-day deadlines

🔹 Receiving sale proceeds directly

🔹 Exchanging into non-qualifying property

🔹 Improper identification of replacement properties

🔹 Assuming a primary residence qualifies

Careful planning matters.

🟢 WHAT A 1031 EXCHANGE DOES NOT DO

It’s important to understand the limits:

🔹 It does not eliminate taxes permanently

🔹 It does not apply to primary residences

🔹 It does not work for property held primarily for resale

🔹 It does not avoid taxes if rules are not followed

1031 exchanges are powerful, but rule-driven.

🟢 A PRACTICAL RULE OF THUMB

🔹 Investment property → may qualify

🔹 Primary residence → does not qualify

🔹 Missed deadlines → exchange fails

🔹 Long-term investor → often a good planning tool

Reviewing eligibility before selling is critical.

🟢 NEED HELP WITH A 1031 EXCHANGE?

1031 exchanges require coordination between real estate, tax, and timing considerations.

At Pacific Change, we help clients:

🔹 Determine whether a property qualifies

🔹 Coordinate with qualified intermediaries

🔹 Understand the tax impact before selling

🔹 Plan exchanges as part of a long-term strategy

If you’re considering selling an investment property and want to understand whether a 1031 exchange makes sense, we’re happy to help.