Tax-Deferred Exchange
1031 Exchange Explained for Real Estate Exam Students
Section 1031 of the Internal Revenue Code allows investors to defer capital gains taxes by swapping one investment property for another. Here's what the exam tests: timelines, like-kind rules, boot, and qualified intermediaries.
What Is a 1031 Exchange?
A 1031 exchange (also called a like-kind exchange or Starker exchange) allows a real estate investor to sell an investment property and reinvest the proceeds into another like-kind property — deferring capital gains taxes that would otherwise be due at sale.
The exchange is authorized under Section 1031 of the Internal Revenue Code. It does not eliminate the tax — it defers it until the replacement property is eventually sold without a subsequent exchange.
Primary residences and personal-use property do not qualify. The property must be held for investment or productive use in a trade or business.
1031 Exchange Exam Questions
Question 1
An investor sells a rental property for $500,000 and wants to defer capital gains tax. What IRS code section applies, and what must the investor do within 45 days of closing?
Section 1031 applies. The investor must identify the replacement property (or properties) in writing within 45 days of the closing date of the relinquished property. This is the identification deadline — missing it disqualifies the exchange.
Question 2
An investor's 1031 exchange involves trading a $400,000 property for a $350,000 replacement. The investor receives $50,000 cash. What is the $50,000 called and how is it taxed?
The $50,000 is called 'boot.' Boot is any non-like-kind property or cash received in an exchange. Boot is taxable in the year received — the investor must pay capital gains tax on the $50,000.
Question 3
What are the two critical 1031 exchange deadlines?
45-day identification rule: The investor must identify replacement property(ies) in writing within 45 days of closing the relinquished property. 180-day closing rule: The investor must close on the replacement property within 180 days of the original sale (or the tax return due date, whichever is earlier).
1031 Exchange Key Rules
Like-kind requirement: Both properties must be real property held for investment or business use.
Equal or greater value: To fully defer taxes, the replacement property must equal or exceed the relinquished property's value.
Qualified intermediary (QI): The investor cannot touch the money. A QI holds exchange funds and transfers them to acquire the replacement property.
Identification period: 45 days from closing the relinquished property to identify replacement property in writing.
Exchange period: 180 days from closing the relinquished property to close on the replacement.
Boot: Cash or non-like-kind property received in the exchange is taxable as capital gain.
3-property rule: Investors can identify up to 3 replacement properties without restriction on value.
1031 Exchange FAQ
Can a primary residence be used in a 1031 exchange?
No. Primary residences are not eligible. Only property held for investment or productive use in a trade or business qualifies.
What is a 'reverse' 1031 exchange?
In a reverse exchange, the investor acquires the replacement property before selling the relinquished property. This is complex, requires an Exchange Accommodation Titleholder (EAT), and must be completed within 180 days.
What is the difference between a Starker exchange and a 1031 exchange?
They are the same thing. 'Starker exchange' refers to a deferred (non-simultaneous) exchange named after the 1979 Starker v. United States case.