Sell a rental at a profit and the tax bill arrives the same year. A 1031 exchange is the provision that lets you put the money into another investment property instead and defer that bill.
The appeal is arithmetic. Tax paid now is money that stops compounding. Tax deferred stays in the next building, working.
What does a 1031 exchange actually cover?
Real property, held for the right reason. The IRS instructions are specific: section 1031 like-kind exchange treatment applies only to exchanges of real property held for use in a trade or business or for investment, other than real property held primarily for sale.
Two things fall out of that sentence. The house you live in is not in scope, and neither is a flip, because property held mainly for sale is excluded by name. A rental you have been letting out is the ordinary case.
“Like-kind” is looser than it sounds for real estate. A single-family rental can be exchanged for a fourplex, land, or a share of a larger building, because all of it is real property held for investment.
What are the 45-day and 180-day deadlines?
They start the day the property you give up is transferred, and they are not negotiable.
The replacement property must be identified within 45 days after the property being given up is transferred, in writing. It must be received within 180 days, or by the due date of your tax return (including extensions), whichever comes first. That last clause catches people who sell late in the year: an exchange that starts in November may have less than 180 days unless the return is extended.
Forty-five days is the pressure point. You are picking a building while you are also closing a sale, which is why most people shortlist before listing.
A rental sold in year 10, and what it frees up
Start with the house the rental calculator opens on: $250,000, renting for $2,750 a month, bought with 20% down at 7%. It clears $420 a month. Hold it ten years with values growing 3% a year and sell at 7% selling costs. The growth rate is the example’s assumption.
| Amount | |
|---|---|
| House value in year 10 | $335,979 |
| Selling costs (7%) | −$23,518 |
| Loan payoff | −$171,625 |
| Cash from the sale | $140,836 |
These are example figures, not a forecast for any market.
$140,836 is what the sale frees up. Sell outright and part of it goes to tax on the gain and on the depreciation you claimed along the way. Exchange it and the whole figure moves.
What happens to the cash you keep?
It becomes taxable. This is the rule that surprises people.
Take the fourplex the multifamily calculator opens on: $499,000, four units at $1,575 each. At 20% down with 3% closing costs it needs $114,770. The sale freed $140,836, so there is $26,066 spare.
| Amount | |
|---|---|
| Down payment on the fourplex (20%) | $99,800 |
| Closing costs (3%) | $14,970 |
| Cash you keep | $26,066 |
| Cash from the sale | $140,836 |
On the money and property received outside the exchange, the instructions say gain is recognized to the extent of the other property and money received, but a loss isn’t recognized. So the $26,066 you take off the table is gain you recognize now, up to the gain in the deal. The $114,770 that went into the fourplex is the part that is deferred.
How much tax that $26,066 actually triggers depends on your basis, the depreciation you claimed and your own rates. That is a calculation for a tax professional, not a blog post, and the exchange itself gets reported on Form 8824.
Does the bigger building earn more?
On these inputs, yes, and the gap is wide.
The fourplex collects $6,300 a month in scheduled rent. After 6% for empty units, $533 a month of property tax, $300 of insurance, $450 of common-area utilities, 5% of the rent roll for repairs, 5% for replacements and 8% for management, and a $2,656 mortgage payment, it clears $849 a month. That is 8.9% on the $114,770 of cash in it, with $42,056 of yearly operating income and 1.32 times the loan payment covered.
The single house cleared $420 a month on $57,500. The exchange turned one tenant into four and roughly doubled the monthly figure, using money that would otherwise have been split with the IRS. It also doubled the repair surface: four roofs’ worth of building, four furnaces, four turnovers. For how the four-unit numbers are built up, see how to analyze a multifamily property.
Whether that trade is worth making is a different question from whether the tax is deferred. Ten years of deferral changes the long-run return, and what counts as a good IRR on a rental is the measure that shows it.
Who holds the money in between?
Not you. That is the detail that voids more exchanges than the deadlines do.
Touch the sale proceeds and you have taken a cash sale. The instructions describe the workaround: if you make a deferred exchange using a qualified intermediary (QI), the transfer of the property given up and receipt of like-kind property is treated as a like-kind exchange. The intermediary holds the money and buys the replacement. Two limits are worth knowing before you pick one: related parties and agents of the taxpayer aren’t eligible to be QIs, and if you fail to meet the timing requirements because of the QI, your transaction won’t qualify as a deferred exchange.
So the intermediary is lined up before the sale closes, not after.
Where to start
Run the building you would exchange into before you list the one you own. Put the proceeds in as the down payment and see what the replacement clears each month, because a deferred tax bill does not help a property that loses money.
If the answer is that you would rather hold the house than trade it, renting it out against selling it is the comparison to run first.