In real estate and tax law, a 1031 exchange is when you replace one investment property with another in a short amount of time in order to avoid capital gains taxes and depreciation recapture. Section 1031 of the US Internal Revenue Code states that any income generated from selling an investment property will incur capital gains taxes. However, if the seller invests that income in a new property that is of equal or greater value, the seller can avoid capital gains taxes. 

Also known as a like-kind exchange, 1031 exchanges must be made with similar properties to be recognized for tax deferral by the IRS. Real estate investors that sell and buy investment properties in a 1031 exchange must use a qualified intermediary to transfer finances from the sold property to the new property.
The 1031 exchange does not apply to primary residences but it can apply to rental properties, vacation homes, apartment buildings, and business properties. Beyond those rules, there are four requirements that an owner’s investment property exchange must meet to qualify for a  1031 deduction. 

- __Property value__: The [market value](https://www.masterclass.com/articles/fair-market-value-explained) of the new investment property must be of equal or greater value than the relinquished property. 
- __Use of funds__: The property owner must use all of the income they received from selling the relinquished property towards the purchase of the new exchange property.
- __Property type__: Both the sold property and the replacement property must be considered like-kind properties. For example, residential rental properties should be exchanged for other rental properties, and commercial properties can be exchanged for other commercial properties.
- __Timeline__: A 1031 property exchange must occur within about a six-month time frame to be valid. The potential replacement property must be identified within 45 days of the sale of the original property. The investor must then buy the replacement property within 180 days. For this reason, the 1031 exchange is also known as a delayed exchange.
The 1031 exchange allows taxpayers to perform a tax-deferred exchange of investment properties, meaning that capital gains taxes are not owed on a property sale. 

1. __The investor selects a qualified intermediary__. Once the [investor’s](https://www.masterclass.com/articles/how-to-become-a-real-estate-investor) relinquished property is under contract, they must decide who will act as their qualified intermediary. This person acts as a trustee who handles the exchange of funds during the entire transaction. They hold the money from the sale of the relinquished property when it sells, and disburse these funds to the investor when they buy their new property.
2. __The investor relinquishes their original property__. The first step in this process is for the seller who intends to perform a 1031 exchange to sell their property. On the day that their original property closes and the new owner takes possession of it, the 1031 exchange timeline begins. 
3. __The investor finds their replacement property within 45 days__. The investor must identify their proposed replacement property within 45 days of selling the relinquished property. Failure to do this within the 45 day period will cancel the 1031 exchange and they will have to pay capital gains taxes on any income generated from this exchange. 
4. __The investor closes on the replacement property within 180 days__. The investor must close on their new investment property within 180 days of relinquishing their original property (135 days after finding their replacement property). The qualified intermediary will transfer all the sale proceeds from the relinquished property to purchase the new property. The investor covers the difference if the new property is of a higher value.
5. __The investor notifies their tax advisor__. Once the 1031 exchange is complete, the investor should notify their tax advisor of the transaction so that they can properly document it on their income tax return.
All investments, including real estate investments, come with inherent risks which may involve the depreciation of assets, financial losses, or legal ramifications. The information presented in this article is for educational, informational, and referential purposes only. Consult a licensed real estate or financial professional before making any legal or financial commitments.
All you need is a [MasterClass Annual Membership](https://www.masterclass.com) and our exclusive video lessons from prolific entrepreneur Robert Reffkin, the founder and CEO of the real estate technology company Compass. With Robert’s help, you’ll learn all about the intricacies of buying a home, from securing a mortgage to hiring an agent to tips for putting your own place on the market. 
Real estate investors can use the 1031 exchange to sell and buy investment properties while avoiding capital gains tax liability.

Real estate investors can use the 1031 exchange to sell and buy investment properties while avoiding capital gains tax liability.

Guide to 1031 Exchange: How a 1031 Exchange Works

In real estate and tax law, a 1031 exchange is when you replace one investment property with another in a short amount of time in order to avoid capital gains taxes and depreciation recapture. Section 1031 of the US Internal Revenue Code states that any income generated from selling an investment property will incur capital gains taxes. However, if the seller invests that income in a new property that is of equal or greater value, the seller can avoid capital gains taxes. Also known as a like-kind exchange, 1031 exchanges must be made with similar properties to be recognized for tax deferral by the IRS. Real estate investors that sell and buy investment properties in a 1031 exchange must use a qualified intermediary to transfer finances from the sold property to the new property.

What Is a 1031 Exchange?

The 1031 exchange does not apply to primary residences but it can apply to rental properties, vacation homes, apartment buildings, and business properties. Beyond those rules, there are four requirements that an owner’s investment property exchange must meet to qualify for a 1031 deduction. <ul class="mc-m-4 list-styled"><li class="">Property value: The <a href='https://www.masterclass.com/articles/fair-market-value-explained' target='_self' class='mc-text--link' data-mc-segment-trigger='true' data-mc-segment-event-type='Article Page Click' data-event-obj='{"textTag":"p","href":"https://www.masterclass.com/articles/fair-market-value-explained","linkCopy":"market value","category":null}'>market value</a> of the new investment property must be of equal or greater value than the relinquished property. </li><li class="">Use of funds: The property owner must use all of the income they received from selling the relinquished property towards the purchase of the new exchange property. </li><li class="">Property type: Both the sold property and the replacement property must be considered like-kind properties. For example, residential rental properties should be exchanged for other rental properties, and commercial properties can be exchanged for other commercial properties. </li><li class="">Timeline: A 1031 property exchange must occur within about a six-month time frame to be valid. The potential replacement property must be identified within 45 days of the sale of the original property. The investor must then buy the replacement property within 180 days. For this reason, the 1031 exchange is also known as a delayed exchange. </li></ul>

What Are the Requirements for a 1031 Exchange?

The 1031 exchange allows taxpayers to perform a tax-deferred exchange of investment properties, meaning that capital gains taxes are not owed on a property sale. <ol class="mc-m-4"><li class="mc-my-4"> 1. The investor selects a qualified intermediary. Once the <a href='https://www.masterclass.com/articles/how-to-become-a-real-estate-investor' target='_self' class='mc-text--link' data-mc-segment-trigger='true' data-mc-segment-event-type='Article Page Click' data-event-obj='{"textTag":"p","href":"https://www.masterclass.com/articles/how-to-become-a-real-estate-investor","linkCopy":"investor’s","category":null}'>investor’s</a> relinquished property is under contract, they must decide who will act as their qualified intermediary. This person acts as a trustee who handles the exchange of funds during the entire transaction. They hold the money from the sale of the relinquished property when it sells, and disburse these funds to the investor when they buy their new property. </li><li class="mc-my-4"> 2. The investor relinquishes their original property. The first step in this process is for the seller who intends to perform a 1031 exchange to sell their property. On the day that their original property closes and the new owner takes possession of it, the 1031 exchange timeline begins. </li><li class="mc-my-4"> 3. The investor finds their replacement property within 45 days. The investor must identify their proposed replacement property within 45 days of selling the relinquished property. Failure to do this within the 45 day period will cancel the 1031 exchange and they will have to pay capital gains taxes on any income generated from this exchange. </li><li class="mc-my-4"> 4. The investor closes on the replacement property within 180 days. The investor must close on their new investment property within 180 days of relinquishing their original property (135 days after finding their replacement property). The qualified intermediary will transfer all the sale proceeds from the relinquished property to purchase the new property. The investor covers the difference if the new property is of a higher value. </li><li class="mc-my-4"> 5. The investor notifies their tax advisor. Once the 1031 exchange is complete, the investor should notify their tax advisor of the transaction so that they can properly document it on their income tax return. </li></ol>

How Does a 1031 Exchange Work?

All investments, including real estate investments, come with inherent risks which may involve the depreciation of assets, financial losses, or legal ramifications. The information presented in this article is for educational, informational, and referential purposes only. Consult a licensed real estate or financial professional before making any legal or financial commitments.

A Note on Real Estate Investment

All you need is a <a href='https://www.masterclass.com' target='_self' class='mc-text--link' data-mc-segment-trigger='true' data-mc-segment-event-type='Article Page Click' data-event-obj='{"textTag":"p","href":"https://www.masterclass.com","linkCopy":"MasterClass Annual Membership","category":null}'>MasterClass Annual Membership</a> and our exclusive video lessons from prolific entrepreneur Robert Reffkin, the founder and CEO of the real estate technology company Compass. With Robert’s help, you’ll learn all about the intricacies of buying a home, from securing a mortgage to hiring an agent to tips for putting your own place on the market.

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Real estate investors can use the 1031 exchange to sell and buy investment properties while avoiding capital gains tax liability.

Real estate investors can use the 1031 exchange to sell and buy investment properties while avoiding capital gains tax liability.
