Setting Up a 1031 Exchange: Essential Information and Required Documents

Savvy real estate investors turn to 1031 exchanges as a powerful way to defer capital gains taxes and keep more money working for them. But while the financial upside can be significant, the process is tightly regulated by the IRS, with strict rules and deadlines that must be met. 

In this guide, we walk through everything you need to know about setting up a 1031 exchange, including a detailed breakdown of the steps involved and the documentation required along the way.

Understanding the Basics 

A 1031 exchange is not a tax loophole or exemption, but rather a legal deferral mechanism. The primary advantage is the ability to defer paying capital gains taxes when you sell an investment property, as long as you reinvest the proceeds into another property of equal or greater value. This process allows your capital to grow without being diminished by taxes, enabling long-term wealth-building through strategic real estate reinvestment.

Before beginning the exchange, you must confirm that the property you are selling qualifies. Only properties held for investment or business use are eligible. Personal residences, second homes or properties held primarily for resale do not qualify. The replacement property must also be used for investment or business purposes and must be considered "like-kind" to the relinquished property. Fortunately, the definition of "like-kind" in real estate is broad. For example, you can exchange a rental property for raw land or an industrial building for a shopping center.

Step 1: Planning and Professional Support 

The first step in a successful 1031 exchange is to build a support team. This typically includes a tax advisor or CPA, a real estate attorney and, most importantly, a Qualified Intermediary (QI). The IRS requires a QI to handle the transaction; without one, your exchange will not be valid. The QI prepares legal documents, holds the proceeds from the sale in escrow and ensures funds are properly transferred to the replacement property.

Be sure to engage a QI before the sale of your property closes. If you take possession of the proceeds, the transaction will no longer qualify as a 1031 exchange. Your QI will draft an exchange agreement, assign the purchase and sale contracts to the exchange and provide notices to both the buyer and seller confirming the exchange structure.

Step 2: Selling the Relinquished Property 

Once you have your team in place, you can list and sell your relinquished (original) property. During the sales process, language in the purchase agreement must disclose your intent to conduct a 1031 exchange and confirm the buyer's willingness to cooperate. This language should not impose any obligations or liability on the buyer but should keep the process transparent and legally compliant.

At closing, the proceeds from the sale must be wired directly to the QI — not to you — to maintain IRS compliance. From that date, the 45-day identification window begins. It’s the first of two critical deadlines you will need to meet in a 1031 exchange.

Step 3: Identifying Replacement Properties 

You have 45 calendar days from the sale of your relinquished property to identify potential replacement properties. This identification must be in writing, signed, dated and delivered to your QI. There are several identification rules that must be followed:

• Under the three property rule, you can identify up to three properties regardless of their market value.
• The 200% rule allows you to identify more than three properties, as long as their total fair market value does not exceed 200% of the value of your relinquished property.
• The 95% rule permits you to identify more than three properties of any value, provided you actually acquire 95% of the total value identified.

To stay ahead of the 45-day deadline, it’s wise to begin searching for replacement properties before your sale closes. It's also recommended to identify backup properties in case your preferred choices fall through during negotiation or inspection.

Step 4: Conducting Due Diligence 

Once you've identified potential replacement properties, you will enter the due diligence phase. This process involves evaluating the properties in depth to ensure they align with your investment goals and are free from significant issues. Activities during this phase may include property inspections, title searches, appraisals and zoning or land use verifications. For income-producing properties, you may also review existing lease agreements or rent rolls.

Additionally, your replacement property must meet the "equal or greater value" requirement, which ensures that all the equity from the relinquished property is reinvested. Any shortfall in value (called "boot") may be taxable.

Step 5: Closing on the Replacement Property 

The second critical IRS deadline is the 180-day rule. From the date you sold your original property, you have 180 calendar days to close on the purchase of your replacement property. This timeline includes the 45-day identification window and cannot be extended.

Your QI will use the held proceeds to purchase the replacement property. To maintain compliance, the exchange funds must never come into your direct control. The replacement property's closing documents should clearly show that the QI is acting on your behalf as part of a 1031 exchange. Your attorney or escrow officer will work with the QI to coordinate the transfer of funds and ensure that all documentation meets IRS requirements.

Step 6: Filing and Final Documentation 

Once the exchange is complete, you will need to report it on your federal tax return for the year the sale occurred. This is done using IRS Form 8824, "Like-Kind Exchanges." The form requires detailed information about both the relinquished and replacement properties, the dates of sale and acquisition, the value of each property and any gain deferred or recognized. Your tax advisor or CPA can help ensure everything is reported accurately.

In addition to IRS Form 8824, you will retain a package of documents including the Exchange Agreement, the Assignment of Sale and Purchase Contracts, the Identification Letter and the final HUD-1 or ALTA closing statements for both transactions. These documents serve as proof that the exchange was conducted in accordance with IRS regulations.

Common Pitfalls to Avoid

Several common mistakes can derail a 1031 exchange and lead to unexpected tax consequences. Among the most frequent: missing the 45-day or 180-day deadlines, failing to use a QI, identifying properties improperly or receiving cash proceeds during the transaction. Any of these errors can result in partial or full disqualification of the exchange.

It’s also important to understand what types of properties qualify. A common misconception is that personal residences or fix-and-flip properties qualify for a 1031 exchange. However, the IRS requires that both the relinquished and replacement properties be held for investment or used in a trade or business. Properties held for short-term resale or personal use typically do not meet these criteria.

Start Your 1031 Exchange With Confidence

A successful 1031 exchange takes more than just good timing — it requires strategy, precision and the right team behind you. When properly executed, it can unlock significant tax deferral benefits and support long-term portfolio growth. But every step matters. Whether you are upgrading, consolidating or diversifying your investment real estate, understanding the mechanics and requirements of a 1031 exchange is key to maximizing its potential.

Need help setting up a 1031 exchange? The experts at National 1031 will help you get through every stage of the process successfully. Contact us to get the answers you need to move forward with confidence.