1031 Exchange

Selling a duplex, triplex or fourplex held for investment? A like-kind exchange may let you defer capital gains taxes by reinvesting in replacement property. Here is a general overview.

Not legal or tax advice

What is a 1031 exchange?

Section 1031 of the Internal Revenue Code allows an investor to defer recognition of capital gain when real property held for investment or for productive use in a trade or business is exchanged for other like-kind real property. Instead of paying tax on the gain at the time of sale, the gain is generally carried over into the replacement property.

For 2-4 unit owners, exchanges are a common way to trade up: from a duplex to a fourplex, from several small properties into one, or into a different market, while keeping more equity working.

General requirements

In general terms, an exchange typically involves the following. Your advisors will confirm how each applies to you.

Both the relinquished and replacement properties are held for investment or business use. A personal residence generally does not qualify, though mixed-use situations (such as an owner-occupied duplex) need professional analysis.
The properties are like-kind real property. Most U.S. investment real estate is considered like-kind to other U.S. investment real estate.
The same taxpayer generally sells the relinquished property and acquires the replacement property.
You do not take actual or constructive receipt of the sale proceeds; a qualified intermediary typically holds them.
To defer all of the gain, investors commonly aim to buy replacement property of equal or greater value and reinvest all net proceeds. Cash or debt relief not replaced (often called boot) may be taxable.

Identification and exchange periods

45 days

Identification period

Typically, replacement property must be identified in writing within 45 calendar days after the relinquished property transfers.

180 days

Exchange period

Typically, the replacement property must be acquired within 180 calendar days of the transfer, or by the due date of your tax return (with extensions) if earlier.

The two periods run concurrently, not consecutively, and generally are not extended for weekends or holidays. Confirm your exact deadlines with your qualified intermediary and tax advisor.

Replacement property identification rules

Identification is generally limited by one of these commonly described rules:

Three-property rule: identify up to three properties of any value.
200% rule: identify any number of properties whose combined value does not exceed twice the value of the relinquished property.
95% rule: identify more than that, but then acquire at least 95% of the total value identified.

Identification typically must be unambiguous (such as a legal description or street address) and delivered as your intermediary instructs. For 2-4 unit buyers, identifying backup properties can matter because small multifamily inventory can be limited.

Qualified intermediaries

A qualified intermediary (QI), sometimes called an exchange accommodator, is an independent party that prepares the exchange documents and holds the sale proceeds so you do not receive them. The exchange is usually set up with the QI before the relinquished property closes.

Your agent, attorney or accountant who has acted for you recently generally cannot serve as your QI. Ask prospective intermediaries how funds are held and protected, what insurance or bonding they carry, and how they communicate deadlines. We are happy to coordinate with the intermediary you choose.

Common mistakes

Closing the sale before engaging a qualified intermediary.
Receiving sale proceeds, even briefly, instead of having them held by the QI.
Missing the identification deadline, or identifying vaguely.
Buying replacement property of lower value, or taking cash out, without understanding the tax on boot.
Replacing less debt than was paid off without adding cash to offset it.
Titling the replacement property in a different name or entity than the seller.
Not lining up financing and a property search before the clock starts.

Disclaimer

This page is general information, not legal or tax advice. 2-4 Units is not a qualified intermediary, tax advisor or law firm. Exchange rules are complex and depend on your facts; consult a qualified intermediary, CPA and attorney before selling. Information on this page is summarized for general understanding, may not reflect recent changes in law, and should be confirmed with a qualified intermediary and tax advisor.