Updated · Part of the CRE investment glossary
How a 1031 exchange works
Section 1031(a) says no gain or loss is recognized when real property held for productive use in a trade or business or for investment is exchanged solely for like-kind real property held for the same purposes. Since the Tax Cuts and Jobs Act it applies only to real property, not equipment or other personal property. Real property held primarily for sale, such as a flip, does not qualify.
Real properties are generally like-kind to each other whether improved or not: an apartment building can be exchanged for land or an office building. U.S. property is not like-kind to property outside the United States.
Most exchanges are deferred. The property is sold, a qualified intermediary holds the proceeds, and the replacement is bought later; the seller must not take the cash. Related parties and the seller’s agents cannot act as the intermediary (Form 8824 instructions).
The deadlines
Both clocks start the day the relinquished property is transferred:
- Day 45: identify the replacement property in a signed writing delivered to the intermediary or another party to the exchange (§1031(a)(3)(A)).
- Day 180, or the due date of the tax return for the year of the sale including extensions, if earlier: receive the replacement property (§1031(a)(3)(B)).
- Report the exchange on Form 8824. How many properties you may identify is set by the regulations — ask your intermediary or CPA.
Boot, basis and the formula
Gain is deferred, not forgiven. The deferred gain lowers the basis of the replacement property, so it — including the depreciation part — is taxed when that property is sold in a taxable sale.
Gain recognized = lesser of (realized gain) and (boot received)
- Realized gain: amount realized on the sale minus adjusted basis.
- Boot: cash and non-like-kind property received, plus net liabilities the other party takes on (Form 8824 instructions).
- Basis of the replacement property = its cost − deferred gain.
Worked example: a partial exchange
A partnership sells a building for $5,000,000 net of costs. Its adjusted basis is $2,000,000 and there is no debt. The intermediary buys a $4,700,000 replacement property and pays the remaining $300,000 to the partnership.
If the old building had carried a mortgage paid off at closing, the partnership would generally need to take on as much new debt, or add cash, to avoid boot from the debt relief.
| Line | Arithmetic | Amount |
|---|---|---|
| Realized gain | $5,000,000 − $2,000,000 | $3,000,000 |
| Boot received (cash) | $5,000,000 − $4,700,000 | $300,000 |
| Gain recognized | Lesser of $3,000,000 and $300,000 | $300,000 |
| Gain deferred | $3,000,000 − $300,000 | $2,700,000 |
| Basis of replacement | $4,700,000 − $2,700,000 | $2,000,000 |
Why LP interests do not qualify, and what syndications do
Treasury Regulation §1.1031(a)-3 lists interests in a partnership among the things that are not real property for §1031, even when the partnership owns only real estate. An investor cannot exchange LP units in one syndication for units in another, or roll the proceeds of a property sale into syndication LP units and defer the gain.
The exchange happens at the partnership level: the partnership sells its property, buys the replacement, and the partners stay in. Partners who want cash and partners who want to exchange are hard to serve at once. Sponsors sometimes restructure before a sale — for example distributing tenancy-in-common interests to partners ("drop and swap") — but that carries risk under the held-for-investment requirement and needs tax counsel.
This is also why exchange buyers looking for a passive investment use tenancy-in-common or Delaware statutory trust interests, which can be structured as interests in real property, rather than LP units. Section 1031(e) treats an interest in a partnership that has elected out of subchapter K under §761(a) as an interest in its assets.
Primary sources
General information, not legal, tax or investment advice. Your operating agreement, offering documents, counsel and CPA govern your deal.