Thinking of deferring capital gains tax on an investment property? You’re probably wondering: what are 1031 exchanges, and how do 1031 exchanges work? A 1031 exchange is a powerful tool for real estate investors to grow wealth by deferring taxes when swapping one investment property for another.
In this guide, we’ll walk you through how 1031 exchanges work, the latest rules, tax benefits, what’s not allowed, and advanced strategies — so you can use this method confidently in 2025.
What Is a 1031 Exchange?
A 1031 exchange (also called a like-kind exchange) is a tax-deferred real estate transaction under Section 1031 of the Internal Revenue Code. It allows investors to sell a property and reinvest the proceeds into another “like-kind” investment property, deferring capital gains taxes.
Example:
Sell a rental duplex → buy an office building within set timeframes → pay no capital gains tax now.
How Do 1031 Exchanges Work?
A 1031 exchange isn’t just a simple sale and purchase — it’s a carefully timed process governed by IRS rules. Here’s how it works:
1. Sell the Original Property (Relinquished Property)
You start by selling your current investment property. Proceeds go to a qualified intermediary (QI) — not to you directly.
2. Identify Replacement Properties
You must identify up to three replacement properties within 45 days of selling the first property.
3. Buy a New Investment Property
You must close on at least one of the identified properties within 180 days of the sale.
4. Defer Capital Gains Tax
By reinvesting all proceeds, you defer paying capital gains taxes — freeing up more capital for your next investment.
🔢 Timeline Chart
Day 0: Sell Property A
↓ Within 45 Days: Identify up to 3 new properties
↓ Within 180 Days: Purchase replacement property
1031 Exchange Rules You Must Follow
| Rule | Summary |
| Like-Kind Rule | Replacement property must be similar in nature (any real estate used for investment/business). |
| 45-Day Rule | Identify up to 3 properties within 45 days of selling. |
| 180-Day Rule | Purchase replacement property within 180 days. |
| No “Boot” Rule | Reinvest all proceeds — or pay taxes on leftover cash (boot). |
| Use a Qualified Intermediary | Funds must be held by a neutral third party. |
What Is Not Allowed in a 1031 Exchange?
- Primary residences or second homes
- Flips or property held for resale
- Stocks, bonds, or partnership interests
- Foreign property (must be U.S.-based)
- Personal property (cars, art, etc.)
What Are the Tax Benefits of a 1031 Exchange?
- Defer federal and state capital gains tax
- Defer depreciation recapture
- Buy larger or higher-performing properties
- Preserve investment capital
- Create long-term compounding growth
🧬 Real-Life Example:
Jane sold her $600,000 duplex in Sacramento and reinvested into a $900,000 multi-family unit in Reno using a 1031 exchange. She deferred ~$120,000 in capital gains taxes and increased her monthly cash flow by 35%.
What Is the New Rule for 1031 Exchanges in 2025?
The latest IRS guidance reinforces that 1031 exchanges apply only to real property used in business or investment. Personal property and vacation homes do not qualify.
Also, the Biden administration has proposed a $500,000 cap on deferred gains for individuals. While not yet enacted, this could impact future large-scale exchanges.
What Is the 2-Year Rule for 1031 Exchanges?
This rule applies to exchanges between related parties (e.g., family members or LLCs with shared ownership). Both parties must hold their properties for at least two years post-exchange to avoid disqualification.
What Is the 95% Rule in 1031 Exchange?
An alternative to the 3-property rule, the 95% rule allows identifying any number of properties — but you must purchase 95% of the total value identified.
How to Avoid Taxes on a 1031 Exchange?
- Reinvest 100% of sale proceeds
- Buy a like-kind investment property
- Follow the 45-day and 180-day deadlines
- Use a qualified intermediary
- Avoid receiving any cash or debt relief (“boot”)
Bonus tip: Continue exchanging until your final asset is inherited. Heirs receive a step-up in basis, potentially eliminating deferred tax entirely.
Types of 1031 Exchanges
| Type | Description | Common Use Case |
| Delayed Exchange | Most common, 45/180-day rule applies | Selling one, buying another |
| Reverse Exchange | Buy before selling original | Competitive markets |
| Simultaneous | Sell and buy same day | Rare; harder to execute |
Depreciation Recapture & Estate Planning
If you’ve claimed depreciation on your property, a 1031 exchange helps you defer depreciation recapture taxes — but not eliminate them.
When investors pass away, their heirs receive a step-up in basis, wiping out deferred taxes. This makes 1031 exchanges a powerful estate planning strategy.
Who Should Use a 1031 Exchange?
- Real estate investors upgrading to larger assets
- Retiring landlords reducing management burden
- Commercial property owners relocating or diversifying
- Long-term wealth builders using compound tax deferral
Quick Reference: 1031 Exchange Timeline
| Step | Timeframe |
| Sell original property | Day 0 |
| Identify replacement property | Within 45 days |
| Close on replacement property | Within 180 days |
| File appropriate forms with IRS | With annual return |
FAQs
What is a 1031 exchange in real estate?
A 1031 exchange allows real estate investors to defer capital gains taxes by reinvesting proceeds from a sale into a like-kind investment property.
Can I do a 1031 exchange on a second home?
No. Only properties used for business or investment qualify.
Is a 1031 exchange worth it?
Yes — if done correctly, it defers taxes and grows your investment potential. Working with professionals like a real estate advisor, tax expert, and even a home inspector can help ensure a smooth exchange.
How much does a 1031 exchange cost?
Costs range from $1,000–$2,500, depending on complexity and intermediary fees.
Can I do a 1031 exchange out of state?
Yes. The replacement property must be within the U.S., but it does not need to be in the same state.
Can I do multiple 1031 exchanges?
Yes. There’s no limit to how often you can do a 1031 exchange
