1031 Exchange

A 1031 exchange is a swap of one investment property for another that lets you defer the capital gains tax you would otherwise owe on the sale, named after Section 1031 of the Internal Revenue Code. The deferral is not automatic: you have to identify the replacement property within 45 days of closing the sale, close on it within 180 days, and route the money through a qualified intermediary so you never touch the proceeds.

In practice

Say you bought a duplex years ago for $260,000 and you sell it today for $440,000. After depreciation, your adjusted basis has dropped to roughly $200,000, so your taxable gain is about $240,000. A straight sale could trigger federal capital gains plus depreciation recapture on the part of the gain that came from write-offs you already took. In a 1031 exchange you instead direct the $440,000 to a qualified intermediary at closing, identify a fourplex worth $480,000 within 45 days, and close on it within 180 days. You roll the full $240,000 gain into the new property and pay no tax that year.

The deferred gain does not disappear. It rides along in your basis: the new fourplex carries the old, lower basis (adjusted for the extra cash you put in), so a future sale without another exchange brings the whole deferred amount back. If you take cash off the table or trade down in value, that difference, called boot, is taxable now.

Why it matters to a small landlord

For a one to ten unit owner, the appeal is plain: you can move from a tired duplex into a larger building, or out of a slow market into a faster one, without losing a third of your equity to tax in the year you trade. The cost is the strictness. Miss the 45-day identification window by a day and the whole thing collapses into a taxable sale. The deferred gain also keeps growing in the background because the replacement property inherits your old basis, which means a smaller depreciation deduction going forward than a fresh purchase would give you. Before you commit, it helps to understand how depreciation works on a rental, since the recapture you are deferring is built on those same numbers.

A 1031 exchange is really three glossary terms working together: the capital gains you are deferring, the depreciation recapture that rides with them, and the cost basis that carries over into the new property and decides what you owe when you finally sell for cash. Treat the dates as hard walls and line up your intermediary before you list.