How to Execute a 1031 Like-Kind Exchange for Real Estate Clients
A 1031 like-kind exchange allows a client selling real property held for business or investment to defer all capital gains and depreciation recapture tax — provided the proceeds are reinvested in qualifying replacement property through a qualified intermediary. On a $1,000,000 gain, the combined federal capital gains and depreciation recapture tax deferred can exceed $250,000. The mechanism is entirely mechanical: miss the qualified intermediary requirement, violate the 45-day identification window, or allow the client to touch the sale proceeds, and the exchange fails — with full gain recognition in the year of sale. This guide walks through each step CPAs must sequence for a successful exchange under IRC §1031.
Prerequisites
- Client holds real property for use in a trade or business or for investment — personal residences do not qualify for §1031 (though a §121 exclusion may apply; see Rev. Proc. 2005-14 for combined §121/§1031 treatment on properties with mixed history — details in How to Apply the Primary Residence Sale Exclusion (IRC §121))
- Property is U.S. real property; foreign property exchanges are permitted only with other foreign property (IRC §1031(h))
- The property is not stock in trade or inventory, securities, partnership interests, certificates of trust, or choses in action — these are explicitly excluded under IRC §1031(a)(2)
- The TCJA (P.L. 115-97) eliminated like-kind exchange treatment for personal property beginning January 1, 2018; only real property qualifies for §1031 exchanges for property placed in service after that date — for clients with capital gains from stock sales, business interest sales, or other non-real property dispositions, a Qualified Opportunity Fund (QOF) investment under IRC §1400Z-2 is a separate deferral mechanism with a 10-year appreciation exclusion; see Qualified Opportunity Zone Tax Incentives
- Client has not already received any proceeds from the sale; once proceeds are in the client's hands, the exchange fails
Step 1: Engage a Qualified Intermediary Before Closing
The qualified intermediary (QI) — also called an exchange accommodator or facilitator — must be in place before the relinquished property closes. This is the most common exchange failure point: clients who close on the sale before engaging a QI cannot retroactively structure the proceeds as an exchange.
Under Treas. Reg. §1.1031(k)-1(g)(4), a QI is a person who is not the taxpayer or a disqualified person (agent, attorney, accountant, broker, or employee who has acted in that capacity for the taxpayer within the prior two years), and who enters into a written exchange agreement with the taxpayer. The QI must:
- Enter a written exchange agreement with the taxpayer before the relinquished property closes
- Be assigned the rights to sell the relinquished property under the purchase and sale agreement
- Receive the sale proceeds directly from the closing — the taxpayer cannot receive, pledge, borrow against, or otherwise benefit from the funds during the exchange period
- Hold the proceeds in a segregated account until applied to the purchase of the replacement property
Practical steps:
- Select a QI with appropriate fidelity bonding and errors-and-omissions coverage; QI industry has no federal licensing requirement, so financial capacity matters
- Execute the exchange agreement and assignment of purchase contract at least 2–3 business days before the relinquished property closing
- Amend the purchase and sale agreement (or have the QI issue a notice of assignment) to reflect the QI as the seller of record for exchange purposes
- Provide the closing attorney or title company with wiring instructions directing sale proceeds to the QI's exchange account
Step 2: Close on the Relinquished Property — and Start the Clock
The exchange period begins on the date the relinquished property closes, or on the date a written agreement to transfer beneficial ownership is executed, if earlier (Treas. Reg. §1.1031(k)-1(b)(2)). From this date, two simultaneous deadlines begin running:
- 45-day identification period: The taxpayer must identify potential replacement properties in writing to the QI by midnight of the 45th calendar day after closing. No extensions, no exceptions — neither the IRS nor any court has authority to waive this deadline (PLR 200329021; Hewitt v. Commissioner, T.C. Memo. 2020-89)
- 180-day exchange period (or return due date, whichever is earlier): The taxpayer must close on replacement property within 180 calendar days of the relinquished property closing — or by the due date of the tax return (including extensions) for the tax year in which the exchange began, if that date is earlier
The return-due-date trap: For a relinquished property that closes on October 1, the 180-day exchange period runs through March 30 — but the taxpayer's federal return is due April 15 (or March 15 for a calendar-year S-Corp or partnership). The 180-day period is the controlling deadline only if it falls before the return due date. For fall closings, file an extension immediately to push the return due date past the 180-day period, or the client loses the back portion of the exchange window.
Step 3: Identify Replacement Property Within 45 Days
The identification must be made in writing, signed by the taxpayer, and delivered to the QI (or another person involved in the exchange who is not the taxpayer's agent) by midnight on the 45th day. Treas. Reg. §1.1031(k)-1(c) permits identification of multiple properties under one of three rules:
| Rule | Limit | Notes |
|---|---|---|
| Three-Property Rule | Up to 3 properties, any value | Safest; most commonly used |
| 200% Rule | Any number of properties, total FMV ≤ 200% of relinquished property FMV | Useful when client wants optionality on multiple targets |
| 95% Rule | Any number of properties, any value — but must actually acquire 95%+ of total FMV identified | Almost never practical; used in narrow circumstances |
Identification requirements: The identification must describe the property with specificity — address and legal description for real property, or a general description sufficient to distinguish it (Treas. Reg. §1.1031(k)-1(c)(3)). "A single-family rental property in Phoenix, Arizona" does not satisfy the requirement. A street address does.
Practical tips:
- Identify more properties than you expect to acquire, using the Three-Property Rule as a safety net
- Identification can be revoked and resubmitted before the 45-day deadline; after the deadline, the identified list is locked
- If no replacement property is acquired by Day 180 from the identified list, the exchange fails; any unacquired properties on the list cannot be substituted
- Unused exchange funds return to the taxpayer and are taxable as gain in the year of receipt (not retroactively as of the relinquished property closing)
Step 4: Close on Replacement Property Within 180 Days
The replacement property must be acquired (title transferred) within the 180-day exchange period. The QI wires the exchange proceeds to the replacement property closing; any additional cash the client contributes to cover a purchase price above the exchange balance comes from the client's own funds.
Like-kind requirement: Post-TCJA, "like-kind" for real property is broadly defined — any real property held for business or investment qualifies as like-kind to any other real property held for business or investment (Treas. Reg. §1.1031(a)-1(b)). A client can exchange:
- Improved commercial property for vacant land
- A single-family rental for a shopping center
- Farmland for an industrial warehouse
- A net-lease property for an apartment building
The properties do not need to be similar in use, size, or character — only both must be real property held for the qualifying purpose.
Hold period: The IRS has not established a bright-line minimum hold period, but a pattern of immediate resale of replacement property suggests the property was not held for investment (Treasury Preamble to Treas. Reg. §1.1031(a)-3). A holding period of at least one to two years before sale is a reasonable planning target, subject to facts and circumstances.
Step 5: Calculate Boot and Identify Any Taxable Gain
A fully tax-deferred exchange requires the client to acquire replacement property of equal or greater value and reinvest all net exchange proceeds. Any shortfall is "boot" — the receipt of non-like-kind property or cash — and is taxable in the year of the exchange (IRC §1031(b)).
Boot categories:
| Boot Type | Description | Tax Treatment |
|---|---|---|
| Cash boot | Exchange proceeds not reinvested in replacement property | Taxable gain to the extent of realized gain |
| Mortgage boot (debt reduction) | Net reduction in mortgage debt from relinquished to replacement property | Treated as cash boot; taxable gain |
| Personal property received | Any non-real property included in the sale | Taxable at ordinary or capital gain rates depending on property type |
Boot offset rule: Cash paid into the exchange (additional equity from the client's own funds) offsets mortgage boot dollar-for-dollar, but does not eliminate cash boot already received.
Example:
| Amount | |
|---|---|
| Relinquished property selling price | $1,500,000 |
| Mortgage on relinquished property | $600,000 |
| Net exchange proceeds to QI | $900,000 |
| Replacement property purchase price | $1,400,000 |
| Mortgage on replacement property | $550,000 |
| Cash from client's own funds | $150,000 |
| Exchange proceeds applied | $900,000 |
| Mortgage boot (debt relief: $600k - $550k) | $50,000 |
| Cash boot offset (client cash: $150k reduces $50k mortgage boot to $0) | $0 taxable boot |
In this example, the client's additional cash contribution of $150,000 more than offsets the $50,000 mortgage boot. No boot is recognized; the exchange is fully deferred.
Step 6: Compute the Replacement Property's Carryover Basis
The basis in the replacement property is not the purchase price. It is the carryover basis from the relinquished property, adjusted for any boot received or paid and any gain recognized (IRC §1031(d)).
Formula:
Replacement Property Basis =
Adjusted Basis of Relinquished Property
+ Gain Recognized (boot received)
+ Cash Paid Into Exchange (client's own funds)
- Boot Received
- Liabilities Assumed on Relinquished Property
+ Liabilities Assumed on Replacement Property
The low carryover basis — rather than a stepped-up basis equal to the purchase price — is the deferred liability. When the client eventually sells the replacement property outside of another exchange, the accumulated deferred gain from all prior exchanges in the chain is recognized at that point. Clients who intend to hold the replacement property until death benefit from the stepped-up basis at death under IRC §1014, which eliminates the deferred gain permanently.
Depreciation on replacement property: Because the basis carries over, the client's depreciation schedule on the replacement property blends the carryover basis (depreciated under the remaining recovery period of the relinquished property) with any additional cost basis from the new acquisition (depreciated over a new 27.5-year or 39-year schedule, depending on property type). This bifurcated depreciation schedule is one of the more complex compliance items post-exchange. For property that was previously subject to a cost segregation study, the §1245/§1250 recapture potential carries over into the replacement property's adjusted basis and must be tracked.
For a full walkthrough of how unrecaptured §1250 gain is calculated at the time of sale — including the 25% rate, the "allowed or allowable" depreciation trap, and installment sale interactions — see Depreciation Recapture: How to Calculate and Explain It to Clients Selling Rental Property.
For context on how depreciation acceleration strategies interact with real estate dispositions and basis tracking, see How to Apply Bonus Depreciation and Section 179 for Business Clients in 2025.
For clients who are active real estate investors, the deductibility of losses generated by the replacement property's new depreciation schedule depends on whether they qualify as non-passive under IRC §469. See Real Estate Professional Classification Under IRC §469 for how to determine whether rental losses from the replacement property will offset ordinary income or be suspended under the passive activity loss rules.
Step 7: Report the Exchange on Form 8824
Form 8824 (Like-Kind Exchanges) is filed with the taxpayer's return for the year in which the exchange began — not the year the replacement property was acquired, if those years differ. Key line items:
- Lines 1–7: Description and dates for both properties; confirm the 45-day and 180-day deadlines were met
- Line 12: FMV of like-kind property received
- Line 15: FMV of other property received (boot)
- Lines 18–25: Realized gain calculation, gain recognized (boot), and deferred gain
- Line 25: Basis of replacement property (carries to the depreciation schedule)
Multiple replacement properties: If the client acquired more than one replacement property, a separate Form 8824 is filed for each replacement property, with the realized gain allocated proportionally.
Installment sale interaction: If the relinquished property was sold under an installment arrangement, the exchange rules under Treas. Reg. §15a.453-1 interact with §1031 in ways that require careful analysis. The installment obligation itself may constitute boot unless specifically structured.
Recordkeeping: The exchange file — QI agreement, identification notice, closing statements for both properties, Form 8824 — should be retained as long as the replacement property is held, plus the applicable statute of limitations period after eventual disposition. Because the deferred gain follows the replacement property, the records from the original exchange are material to the tax return in the year of the final sale. For a complete record retention framework for real estate assets and related transactions, see Document Retention Requirements for Business Clients.
Common Mistakes
Allowing the client to receive or control proceeds. The taxpayer cannot have constructive receipt of exchange funds — cannot pledge them as collateral, borrow against them, or instruct the QI to return them at will during the exchange period. Exchange agreements that give the taxpayer an unrestricted right to demand funds during the 180-day period can cause the IRS to treat the full amount as received (Treas. Reg. §1.1031(k)-1(g)(6)).
Missing the 45-day deadline by even one day. The IRS does not grant extensions for the 45-day identification period. Not for federally declared disasters (unless a specific IRS Notice provides relief), not for closing delays, not for illness. Identify at least one property in writing to the QI on or before Day 45, even if the final choice is not yet certain — a property that is later not acquired is better than an expired identification window.
Failing to file a tax return extension before a fall closing. As described in Step 2, a closing in October or November creates a 180-day exchange period that extends into April or May — past the original return due date. Without an extension, the return due date controls, compressing the exchange window. File the extension before the return due date even if the exchange is already in progress.
Misidentifying the property. Identification must be sufficiently specific to distinguish the property from others. Vague descriptions fail. A street address is the practical minimum for improved real property.
Ignoring §1250 unrecaptured depreciation. Even in a successful, fully deferred exchange, the unrecaptured §1250 depreciation from the relinquished property carries over into the replacement property's basis. It does not get deferred in the same way as capital gain — when the replacement property is eventually sold, the unrecaptured §1250 component is taxed at a maximum rate of 25% (IRC §1(h)(1)(D)), regardless of the holding period. Make sure clients understand this component is deferred, not eliminated.
Using a disqualified intermediary. A client's regular attorney, CPA, financial advisor, or a related party cannot serve as the QI. The disqualified person rules under Treas. Reg. §1.1031(k)-1(k) are strict. If the client's attorney handled the sale, they cannot also serve as QI. Use an independent, professionally bonded exchange company.
FAQs
Can a client do a 1031 exchange on a rental property they used to live in?
Yes, with careful structuring. Rev. Proc. 2005-14 provides guidance on coordinating §121 (the primary residence exclusion) with §1031. The property must have been converted to rental use and held as investment property for a sufficient period before the exchange. The §121 exclusion ($250,000 single / $500,000 MFJ) can apply to the residential use portion of the gain, with §1031 deferring the remaining investment property gain. This is fact-intensive; a disqualifying personal use period can collapse the entire structure.
What happens if the replacement property falls through after identification?
If the closing fails after the 45-day identification period but before the 180-day deadline, the client must close on another identified property within the 180-day window. Only properties on the original identification list are eligible — no substitutions after Day 45. If no identified replacement property closes in time, the exchange fails and the QI returns the proceeds to the client, who recognizes gain in the year of the original sale.
Can an S-Corp or LLC do a 1031 exchange?
Yes. The entity — not the individual shareholders or members — must be both the seller of the relinquished property and the buyer of the replacement property. The same taxpayer must be on both sides of the exchange (the "same taxpayer" rule). A partner who wants to exchange their undivided interest separately from the partnership would need a tenancy-in-common arrangement or a drop-and-swap structure, which require careful advance planning and carry their own IRS scrutiny risk.
What is a reverse exchange and when is it useful?
A reverse exchange allows the client to acquire the replacement property before selling the relinquished property — the opposite of the standard exchange sequence. The IRS created a safe harbor under Rev. Proc. 2000-37 that uses an exchange accommodation titleholder (EAT) to hold either the replacement or relinquished property during the exchange. Reverse exchanges are more expensive (the EAT structure carries additional costs) and have the same 45-day and 180-day deadlines — but running in reverse. They are useful when a compelling replacement property comes available before the relinquished property has a buyer.
Does paying down mortgage debt on the replacement property count as cash invested?
No. Additional cash invested at closing in the replacement property (to cover a price above the exchange proceeds) offsets mortgage boot from the relinquished side. But paying down existing replacement property debt after closing does not contribute to exchange equity and has no effect on the boot calculation.
Can a 1031 exchange defer depreciation recapture?
A §1031 exchange defers both capital gain and ordinary income depreciation recapture (§1245 recapture and §1250 unrecaptured gain). The recapture potential carries into the replacement property's adjusted basis and tracks with the carryover depreciation schedule. When the replacement property is eventually sold outside of another exchange, the accumulated §1245 and §1250 recapture is recognized at that time. The 25% rate on unrecaptured §1250 gain is a permanent feature of the deferred tax profile — it does not convert to capital gain rates regardless of hold period.
How does a 1031 exchange affect estimated tax payments in the year of sale?
In a fully deferred exchange with no boot, no gain is recognized — there is no estimated tax liability triggered. If boot is received and gain is recognized, the recognized gain flows through to the client's individual return and increases taxable income for the year. Clients who receive taxable boot mid-year should adjust their Q3 or Q4 estimated tax payment to account for the recognized gain. For the complete safe harbor methodology and payment scheduling, see How to Calculate and File Quarterly Estimated Taxes for Business Clients.
What records should the client retain after completing a 1031 exchange?
Retain the complete exchange file — QI agreement, identification notice, closing settlement statements for both properties, Form 8824, and the original and replacement property depreciation schedules — as long as the replacement property is held plus the applicable statute of limitations after final disposition. Because the deferred gain from a chain of exchanges follows the current replacement property, records from the first exchange in a chain are material to the return filed in the year of the last sale, potentially decades later. See Document Retention Requirements for Business Clients for the complete retention framework.
How Arvori Helps CPAs Manage Complex Transactions
A 1031 exchange requires coordinating QI setup, dual-deadline tracking, basis recalculation, and Form 8824 reporting — all while managing client communications and year-end tax modeling. Arvori gives CPAs a centralized workspace to manage complex multi-step client engagements, track deadlines, and coordinate across the tax planning touchpoints a like-kind exchange involves. Learn more at arvori.app.