Tax Planning with Internal Revenue Code Section 1031

By Michael W. Hurwitz, CPA, MST, Withum

A deferred exchange under Internal Revenue Code (“IRC”) Section 1031 offers real estate investors a strategic method to defer recognition of capital gains taxes when disposing of investment or business-use property. This powerful tax deferral mechanism allows for continued reinvestment of equity and portfolio growth without immediate tax consequences. The Tax Cuts and Jobs Act of 2017 significantly narrowed the scope of IRC Section 1031 by limiting its application to real property only. As a result, exchanges involving personal property, such as equipment, artwork, or vehicles, no longer qualify. For professionals advising clients in real estate transactions, understanding the mechanics and tax implications of both deferred and reverse exchanges under IRC Section 1031 is essential.

The code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind. This provision enables taxpayers to defer capital gains tax that would otherwise be triggered upon the sale of appreciated real estate. Deferred exchanges allow a taxpayer to sell a relinquished property and acquire replacement property later, provided specific timing and procedural requirements are met. Listed below are several key requirements that must be satisfied when entering a deferred exchange:

• Like-Kind Property refers to the nature and character of the property, not its grade or quality. Both relinquished and replacement properties must be of like kind; for real estate, this is broadly interpreted (e.g., an apartment building may be exchanged for raw farmland or a commercial office building exchanged for a retail strip mall). Important exclusions to this apply to personal residences, property held primarily for resale (inventory), and foreign real estate, although foreign for foreign property is allowable.

• Use of a Qualified Intermediary (“QI”) is necessary. The taxpayer must not receive the proceeds from the sale. Instead, a QI holds the funds and facilitates the exchange.

• The taxpayer must identify potential replacement properties within 45 days of transferring the relinquished property. This identification must be in writing and delivered to a QI. There are three rules a taxpayer can use to satisfy this requirement. The taxpayer may identify up to three properties regardless of value (the Three-Property Rule), any number of properties as long as their combined value does not exceed 200% of the relinquished property’s value (the 200% Rule), or more than three properties, even if their total value exceeds 200% of the relinquished property; however, the taxpayer must acquire at least 95% of the total value of the identified properties to qualify.

• The replacement property must be received within 180 days of the transfer (the Exchange Period) or by the due date of the taxpayer’s return (including extensions), whichever is earlier.

In competitive markets or when timing constraints arise, taxpayers may need to acquire the replacement property before disposing of the relinquished property. This structure is known as a reverse exchange, and it is governed by Internal Revenue Procedure 2000-37. Because the taxpayer cannot hold title to both properties simultaneously and still qualify under IRC Section 1031, the transaction must be structured using an Exchange Accommodation Titleholder (EAT) as opposed to a QI. The EAT temporarily holds title to either the relinquished or replacement property in a “qualified parking arrangement” until the exchange is completed. Reverse exchanges are more complex and typically more expensive than standard deferred exchanges, but they offer critical flexibility for investors navigating tight timelines or financing constraints.

Crucial elements of a reverse exchange include:

• EAT Ownership: The EAT takes legal title to one of the properties and enters into a Qualified Exchange Accommodation Agreement with the taxpayer.

• 180-Day Completion Window: The taxpayer must complete the exchange within 180 days of the EAT acquiring the parked property.

• Identification and exchange periods still apply, and the transaction must be carefully documented to meet IRS standards.

Compliance with IRC Section 1031 allows a taxpayer to defer recognition of gain until the replacement property is ultimately sold in a taxable transaction. This deferral can span decades and allows for continued reinvestment of untaxed equity. If the taxpayer receives non-like-kind property (e.g., cash, mortgage relief, non-real estate assets), this is considered “boot” (derived from an Old English word meaning something given in addition) and may trigger partial gain recognition. A gain is recognized to the extent of boot received. To avoid boot, taxpayers should reinvest the full sale proceeds into the replacement property. Any cash taken out or debt not replaced may trigger partial taxation.

The tax basis of the replacement property is generally the same as the relinquished property, adjusted for boot and other factors. This “carryover basis” affects future depreciation and gain calculations. Choosing replacement properties with high depreciation potential can further enhance tax efficiency. Properties that allow for accelerated depreciation can offset future income and reduce taxable gains, making them especially attractive in a deferred exchange strategy.

Exchanges between related parties are subject to additional scrutiny and may be disqualified if either party disposes of the property within two years. For long-term planning, taxpayers may also consider leveraging the “buy-borrow-die” strategy. By continuing to exchange properties and borrowing against their equity, investors can access liquidity without triggering taxable events. Upon death, heirs receive a step-up in basis, potentially eliminating deferred taxes altogether.

Key strategic actions and considerations for real estate professionals and tax advisors include ensuring clients understand the strict timelines and documentation requirements, coordinate with QI’s and/or EAT’s early in the transaction process, evaluate whether a reverse exchange structure is appropriate based on market conditions and financing needs, and consider the long-term implications of basis carryover, depreciation recapture, and future exit strategies. By mastering the intricacies of IRC Section 1031 exchanges, professionals can help clients preserve equity, enhance portfolio flexibility, and defer substantial tax liabilities thereby transforming a routine transaction into a powerful wealth-building opportunity.

Michael W. Hurwitz, CPA, MST is a partner at Withum.