What Is a 1031 Exchange? Your Comprehensive Guide to Tax-Deferred Real Estate Investing

If you’ve sold or are considering selling commercial or investment real estate, you’ve likely heard about 1031 exchanges. But what exactly are they, and why are they so important?

A 1031 exchange, named after Section 1031 of the Internal Revenue Code, is a tax-deferral strategy that allows investors to sell a property held for business or investment purposes and reinvest the proceeds into a “like-kind” property without immediate tax liability. This allows investors to defer capital gains taxes, potentially increasing their purchasing power and preserving more equity for the future.

Read on to learn the basics of how a 1031 exchange works, when you can use one and why it’s one of the most powerful tax strategies available to real estate investors.

How Does a 1031 Exchange Work?

A 1031 exchange allows real estate investors to defer paying capital gains tax when they sell an investment property, as long as they reinvest the proceeds into another qualifying property of equal or greater value. But the process must follow specific rules set by the IRS.

Here’s a high-level overview of how it works:

Step 1: Sell the relinquished property. Once your property sells, the proceeds can’t go directly to you — they must be held by a Qualified Intermediary (QI). The QI is a neutral third party who facilitates the exchange and ensures the process stays compliant.

Step 2: Identify replacement properties (within 45 days). You’ll have 45 calendar days from the closing of your sale to identify up to three potential replacement properties (or more if you meet certain conditions). This must be done in writing and submitted to your QI.

Step 3: Close on the replacement property ). You’ll have a total of 180 days from the sale of your original property to close on the purchase of the replacement. Your QI transfers the proceeds directly to the title company or law firm assisting with the replacement property purchase.

As long as you meet these requirements and reinvest the full amount into a like-kind property, you can defer your capital gains taxes and keep your investment capital working harder for you.

The Four Types of 1031 Exchanges

Not all 1031 exchanges are handled the same. There are four common types of 1031 exchanges that are utilized in different scenarios: forward (delayed) exchange, simultaneous exchange, reverse exchange and construction (improvement) exchange.

Forward (Delayed) Exchange (Most Common)

This is the most common type of 1031 exchange. In a forward exchange, the investor sells their current property (the "relinquished property") first and then acquires a new property (the "replacement property") within a specified time frame. The investor has 45 days to identify potential replacement properties and 180 days to complete the purchase of the replacement property after the sale of the relinquished property.

Simultaneous Exchange (Original Version, but Not as Common Today)

The original form of a 1031 exchange, a simultaneous exchange follows the same steps as a forward exchange, except the sale of the relinquished property and the purchase of the replacement property occur simultaneously. This makes the 180-day period moot since both transactions happen in one day. Simultaneous exchanges are less common due to the logistical challenges of coordinating both transactions and all invested parties within a very short time frame.

Construction (Improvement) Exchange (Specialized Strategy)

In a construction exchange, the investor may either build a new property or make improvements to an existing property using the proceeds from the sale of the relinquished property. This type of exchange allows investors to customize the replacement property to better suit their investment needs, potentially increasing the property’s value. However, the construction or improvement phase can introduce additional risks, such as cost overruns, construction delays and regulatory hurdles, which must be managed effectively.

Reverse Exchange (Increasingly Common in Competitive Markets)

In a reverse exchange, the investor acquires the replacement property before selling the relinquished property. This strategy is beneficial when an investor wants to secure a specific property before selling the original one. The same 45-day identification and 180-day completion rules apply.

Key 1031 Exchange Rules You Need to Know

While the tax benefits of a 1031 exchange are significant, they’re only available if you follow a strict set of IRS rules. Here are the four main requirements every investor needs to understand before starting an exchange:

1. The property must be “like-kind.”
   The replacement property must be of "like-kind" (similar in nature, character or class) to the property being sold. Almost any real estate held for improvement qualifies, from rental houses to office buildings to farmland. For example, you could exchange a commercial office building for a retail center, or an industrial warehouse for a multifamily property. As long as both the relinquished and replacement properties are held for investment or productive use in a trade or business, they’ll generally meet this requirement.

2. You have 45 days to identify a replacement property.
   From the date you sell your relinquished property, you have 45 calendar days to identify potential replacement properties in writing. This identification must be submitted to your QI and follow specific IRS identification rules. To stay ahead of the deadline, it’s best to start exploring replacement options before your initial sale even closes.
   
   
3. The exchange must be completed within 180 days.
   The entire exchange, including closing on the replacement property, must be finalized within 180 calendar days of the sale of your relinquished property. This timeline runs concurrently with the 45-day identification window, which makes early preparation especially important. Missing the 180-day mark can result in the full transaction being taxable.
   
   
4. You must use a QI.
   To comply with IRS regulations, you cannot take possession of the sale proceeds from your relinquished property. Instead, a QI must hold the funds and facilitate the transaction on your behalf. The QI handles the exchange documentation, holds the funds between transactions and ensures the process remains compliant from start to finish.

Why Should I Use a 1031 Exchange?

When done right, a 1031 exchange can help you preserve more capital, grow your portfolio faster and keep your investments aligned with your goals. By deferring taxes and reinvesting in new opportunities, you can make your money work harder without losing a chunk of it to capital gains taxes. It’s a powerful, IRS-backed tool for real estate investors who want to build long-term wealth while staying compliant.

Start Planning Your 1031 Exchange With Our Team of Experts

National 1031 is committed to providing the most compliant and secure 1031 exchange services in the United States. Our team has over 20 years of experience handling a wide range of exchange transactions, from simple forward exchanges to complex construction exchanges.

Ready to explore your options? Download our free 1031 Exchange Guide or schedule a call with a National 1031 expert today and see how this strategy can fit your investment goals.