November 12, 2025

Sell Property, Skip the Tax Bill? The 1031 Exchange Explained

The 1031 Exchange Explained

A 1031 exchange is one of the most powerful tax-deferral tools available to real estate investors. Normally, selling investment property triggers capital gains taxes, at times exceeding 30% once federal and state rates are combined. By using a 1031 exchange, investors can defer those taxes by reinvesting proceeds into another qualifying property, allowing more money to stay invested and working for them. With careful planning, these deferrals can continue through multiple exchanges, and under current law, gains may be permanently eliminated at death when heirs receive a “step-up” in basis to fair market value.

Suppose an investor buys a rental property for $500,000 and later sells it for $1,000,000, creating a $500,000 gain. Instead of paying $150,000+ in immediate taxes, the investor completes a 1031 exchange and rolls the full $1,000,000 into another property. Years later, that property grows to $1,500,000, and the investor exchanges again, deferring another $500,000 gain. At death, the property is worth $2,500,000, but the heirs receive a step-up in basis to fair market value, effectively wiping out $2,000,000 of deferred gains. If the heirs sell immediately, they can pocket $2,500,000 tax-free (under current tax law). All the while, the property also creates a tax deduction for depreciation, based on the original purchase price of $500,000 divided into 39 years or less, depending on property type.  This depreciation expense needs to be recaptured as income if sold in a regular sale, but not if using a 1031 exchange – and it is never recaptured as income if the property is held until death.

But you may be thinking, “What if I don’t want to be actively involved in real estate for the rest of my life?” Owning real estate doesn’t require you to be hands-on. Many investors choose to exchange into properties that are professionally managed—ranging from single-tenant commercial buildings with long-term leases to multifamily or retail properties overseen by established management companies. These structures can provide stable income with minimal involvement.

To complete a 1031 exchange, strict IRS rules apply, and failing to follow them can disqualify the exchange. If you’re considering a 1031 exchange, here are the key rules every investor should understand before moving forward.

1. Purchase “Like-Kind” Property

The term “like-kind” often confuses investors. In a 1031 exchange, it does not mean the properties must be identical. Instead, it means both properties must be real property held for investment or business purposes.

Examples of like-kind exchanges include:

  • Selling an apartment building and purchasing raw land.
  • Exchanging a rental home for a commercial office property.
  • Swapping farmland for a shopping center.

Personal residences, vacation homes (unless meeting strict requirements), and property held for resale (like fix-and-flips) generally do not qualify.

2. Use a Qualified Intermediary

You cannot handle the exchange funds yourself. The IRS requires the use of a Qualified Intermediary (QI) to facilitate the exchange.

The QI’s responsibilities include:

  • Holding the sale proceeds from your relinquished property in escrow.
  • Preparing the necessary exchange documents.
  • Ensuring the funds are transferred directly to acquire the replacement property.

By using a QI, you avoid constructive receipt of the funds, which would otherwise trigger immediate taxation. Choosing an experienced, trustworthy intermediary is critical to a smooth exchange. Note that your CPA, attorney, or other related parties generally cannot serve as your QI under IRS rules.

3. Follow the Timeline Requirements: 45-Day Identification & 180-Day Closing

The IRS enforces strict deadlines:

  • 45 Days to Identify Replacement Property
    From the date you sell your original property, you have 45 calendar days to identify potential replacement properties in writing. The identification must be unambiguous (such as providing an address or legal description). The IRS also limits how many properties can be identified, with rules such as the 3-property rule.
  • 180 Days to Close
    You must complete the purchase of the replacement property within 180 calendar days of selling the original property—or by the due date of your tax return (including extensions), whichever comes first. To be clear, the 180-day clock doesn’t start after the 45-day one, but rather runs concurrently.

Missing either deadline will disqualify the exchange, making the sale fully taxable. Be sure to have your QI involved to ensure compliance.

Final Thoughts

A 1031 exchange can be a powerful tool to grow your real estate portfolio while deferring or potentially eliminating capital gains tax, but success hinges on following the IRS rules to the letter. By working with a trusted qualified intermediary, understanding the timeline requirements, and ensuring your exchange involves like-kind property, you can maximize the benefits of this strategy.

If you’re considering a 1031 exchange, consult with your CPA and legal advisors to ensure the transaction is structured correctly. At Welgaard CPAs & Advisors, we help investors navigate the complexities of tax rules and make confident decisions about their investments.