1031 Exchanges: Legal Issues, Deadlines, and Common Mistakes

A 1031 exchange is one of the most valuable tools available to commercial real estate investors, and one of the least forgiving. The tax benefit depends on following federal rules about timing, identification, and control of money.

This article covers the legal and contract side of a 1031 exchange. It is not tax advice. Every exchange should be planned with a CPA or tax advisor who can model the tax consequences, while your attorney handles the contracts, title, and closing mechanics.

What Property Qualifies for a 1031 Exchange?

Since 2018, Section 1031 of the Internal Revenue Code applies only to real property held for productive use in a trade or business or for investment, exchanged for like-kind real property that will also be held for business or investment. Personal property no longer qualifies.

“Like-kind” is broad for real estate. In general, an office building can be exchanged for raw land, as long as both are held for business or investment. Two important limits apply: property held primarily for sale (such as lots a developer builds and sells) does not qualify, and U.S. real property and foreign real property are not like-kind to each other.

How Do the 45-Day and 180-Day Deadlines Work?

Two clocks start on the day you transfer the relinquished property (the property you are selling). You must identify potential replacement property within 45 days. You must receive the replacement property by the earlier of 180 days after the transfer or the due date, including extensions, of your federal income tax return for the year of the transfer. The periods run at the same time; the 45 days are not added to the 180.

The tax return trap catches many investors. If you sell late in the year, your return for that year may be due before day 180. File on time without an extension, and your exchange period ends on the filing due date, possibly weeks early. Extending the return preserves the full 180 days, so your CPA should know about the exchange well before the return is prepared.

These deadlines cannot be extended for ordinary hardship. Under Section 7508A, the IRS can postpone them for federally declared disasters and certain other events, but only through a published relief announcement that covers your location and the deadlines involved. Treat day 45 and day 180 as hard walls and schedule closings with room to spare.

What Are the Identification Rules?

Identification must be in writing, signed by you, and delivered before the end of the 45-day period to the person obligated to transfer the replacement property to you or to another party in the exchange who is not a disqualified person (in practice, usually your qualified intermediary). Describe each property clearly, typically by legal description or street address. Property you actually acquire within the 45 days counts as identified. You do not have to buy everything you identify, but you must stay within one of three rules; if you exceed both the three-property and 200% limits and do not meet the 95% rule, you are generally treated as having identified nothing:

Identification often comes before you finish due diligence on the replacement property, so naming backup properties under the three-property rule is a common way to manage that risk.

Why Do You Need a Qualified Intermediary?

In a deferred exchange, you cannot have actual or constructive receipt of the sale proceeds. If the money is paid to you or available on request, the transaction can be treated as a taxable sale. The usual solution is a qualified intermediary (QI). The QI signs an exchange agreement with you, receives the proceeds at the sale closing, and uses them to acquire the replacement property. The agreement must restrict your rights to receive, pledge, borrow, or otherwise obtain the benefit of the funds during the exchange.

Not everyone can serve as your QI. The regulations generally disqualify your agent, including anyone who acted as your attorney, accountant, investment banker or broker, real estate agent or broker, or employee within the two years before the first transfer. Services related only to 1031 exchanges, and routine title, escrow, or trust services from title companies, escrow companies, and financial institutions, do not count. Persons related to you, using a 10% ownership threshold instead of the usual 50%, are also disqualified.

Your money sits with the QI for months, so selection matters. Ask how funds are held and what bond and insurance coverage the QI carries. Engage the QI before the sale closes; an exchange agreement signed after you have received the proceeds is too late.

What Should the Purchase and Sale Contracts Say?

Both contracts in the exchange should be drafted with it in mind. The first key provision is a cooperation clause: the other party agrees to reasonably cooperate with your 1031 exchange, at no additional cost or liability to it, and you may assign your contract rights to a qualified intermediary. It is rarely controversial in the letter of intent or first draft, but raising it at the last minute can create friction. Our article on key terms in a commercial purchase agreement shows how it fits with the rest of the contract.

The second is the assignment itself. Typically, you assign your rights under the sale and purchase contracts to the QI, and the other party to each contract receives written notice of the assignment before closing. Deeds are often still conveyed directly between the actual seller and buyer once the contract rights have been properly assigned. Your QI will usually supply assignment forms, and your attorney should review them against the contract. Also confirm that contingencies and extension rights cannot push a replacement closing past day 180.

What Is the Related-Party Rule?

Exchanges with related parties, such as certain family members or entities you control, are allowed with an extra restriction. Under Section 1031(f), if either you or the related party disposes of the exchanged property within two years after the last transfer in the exchange, the deferred gain is generally recognized as of the date of that later disposition. Exceptions apply for dispositions after the death of either party, certain involuntary conversions, and transactions shown to have no principal purpose of tax avoidance. Structures designed to get around the rule, including routing the exchange through an intermediary, are not protected. If an exchange involves family, affiliated companies, or business partners, talk with your tax advisor before signing anything.

Can You Buy the Replacement Property First?

When the right replacement property appears before you have sold, a reverse exchange may help. Under the IRS safe harbor in Revenue Procedure 2000-37, an exchange accommodation titleholder (EAT) acquires and holds title to the replacement property while you sell the old one. You and the EAT must sign a written agreement within five business days after the EAT takes title, you must identify the property you will sell within 45 days, and the parked property must be transferred within 180 days. A later revenue procedure (Rev. Proc. 2004-51) excludes property you owned during the 180 days before it was transferred to the EAT. The safe harbor only settles who owns the parked property for tax purposes; the exchange as a whole must still satisfy Section 1031. For example, the IRS has said that exchanging real estate for improvements built on land you already own does not qualify.

Reverse exchanges cost more and take more coordination than standard exchanges. The lender, title insurer, and EAT must all agree on the structure, and financing is often the hardest part because the property is titled in someone else’s name during the parking period.

What Is Boot, and Can It Make Part of an Exchange Taxable?

“Boot” is a general term for value you receive in an exchange that is not like-kind property, such as cash taken out at closing. Receiving boot may make part of your gain taxable even though the exchange otherwise qualifies. Changes in the debt on the two properties can also affect the result. These are tax calculations, so your CPA should run the numbers before you sign the contracts.

Who Should Take Title to the Replacement Property?

As a general practice, the same taxpayer that sold the relinquished property should acquire the replacement property. If an LLC sold the old building, the replacement is typically acquired by that same LLC, not by its members individually or a newly formed company.

Investors often want a new single-purpose entity for the replacement property, for liability reasons or because a lender requires it. A single-member LLC that is disregarded for federal income tax purposes (the default unless it elects to be taxed as a corporation) is treated as its owner, so an owner can generally sell in his or her own name and buy through a new single-member LLC, or the reverse (Treas. Reg. § 301.7701-3). An LLC taxed as a corporation, or one with two or more members taxed as a partnership, is a separate taxpayer. Confirm the tax classification with your CPA before you form the new company. See our article on holding commercial real estate in an LLC for broader entity considerations.

How Is a 1031 Exchange Reported?

A like-kind exchange is reported on IRS Form 8824 with the tax return for the year the relinquished property was transferred. Keep a complete exchange file (exchange agreement, identification notice, both closing statements, and QI disbursement records) for your CPA.

Do Virginia and North Carolina Transfer Taxes Still Apply?

A 1031 exchange defers federal income tax. As a general matter, it does not eliminate state and local taxes on recording deeds. Each deed in the exchange is its own recorded conveyance. In Virginia, that generally means recordation taxes, the grantor tax, and any regional fees that apply in the locality. In North Carolina, the excise tax (revenue stamps) is generally due on each deed, and some coastal counties add a local land transfer tax. Budget for these costs on both the sale and the purchase. For details, see our guides to commercial real estate in Virginia and commercial real estate in North Carolina.

Frequently Asked Questions

Can I extend the 45-day or 180-day deadline?

Generally, no. They cannot be extended for ordinary hardship. The IRS can postpone them for federally declared disasters and certain other events under Section 7508A, but only through a relief announcement that covers your situation. If your return for the year of the sale is due before day 180, extending the return preserves the full 180 days.

Can my regular CPA or attorney act as my qualified intermediary?

Usually not. Anyone who acted as your attorney, accountant, broker, real estate agent, or employee within the prior two years is generally disqualified, unless those services related only to 1031 exchanges. Related persons are also disqualified.

Can I exchange a rental house for a commercial building?

Generally yes, if both are held for business or investment. Property held primarily for sale does not qualify.

Is a 1031 exchange still available under current tax law?

Yes. Section 1031 remains available for real property. Your tax advisor can confirm how current law applies to you.

What happens if I receive some cash at closing?

Cash or other non-like-kind property is generally called boot and may be taxable even if the rest of the exchange qualifies. Ask your CPA to review the numbers, including any change in debt, before closing.

Related Articles in This Guide

• The Legal Guide to Commercial Real Estate in Virginia and North Carolina
• Commercial Real Estate Letters of Intent: What to Negotiate Before the Contract
• Key Terms in a Commercial Real Estate Purchase Agreement
• Commercial Real Estate Due Diligence Checklist
• Title Insurance and ALTA Surveys in Commercial Real Estate
• Zoning and Land Use Due Diligence for Commercial Property
• Negotiating a Commercial Lease: What Tenants Should Know
• CAM Charges and Triple Net Leases: How Operating Expenses Really Work
• Personal Guaranties in Commercial Leases: Limiting Your Exposure
• Should You Hold Commercial Real Estate in an LLC?
• Buying or Selling Commercial Real Estate in Virginia
• Buying or Selling Commercial Real Estate in North Carolina

This article provides general information only. It is not legal, tax, or financial advice and does not create an attorney-client relationship. Laws differ by state and change over time. Our attorneys are licensed in Virginia and North Carolina. We assist clients with business transactions involving multiple states. For matters involving the law of a state where we are not licensed, we associate with appropriately licensed counsel or otherwise proceed only as permitted by applicable law.