1031 Exchange Rules, Timelines & Fractional Replacement Options | Lofty

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1031 Exchange: Rules, Timelines, and Fractional Replacement Options

Learn how a 1031 exchange lets rental property owners defer capital gains tax by reinvesting sale proceeds into a like-kind investment.

What a 1031 exchange actually does

Section 1031 of the U.S. tax code lets an investor sell a property held for business or investment use and defer the capital gains tax (plus depreciation recapture) by reinvesting the proceeds into one or more like-kind investment properties. The tax is not erased, it rolls forward into the new property's basis until the investor eventually sells without exchanging.

• Only investment or business-use real estate qualifies. Personal residences and house flips do not.
• After the 2017 Tax Cuts and Jobs Act, 1031 applies to real property only. Personal property no longer qualifies.
• Both equity and the loan balance must usually be replaced to fully defer the tax. Cash or debt left over is taxable "boot."

The two deadlines that trip people up

A 1031 exchange is governed by two strict clocks that start the day the relinquished property closes. Missing either deadline can disqualify the exchange.

• 45-day identification: replacement properties must be identified in writing and delivered to the qualified intermediary within 45 calendar days.
• 180-day completion: the replacement property must be acquired within 180 calendar days, regardless of weekends, holidays, or extensions.
• A qualified intermediary (QI) must hold the sale proceeds. If the investor takes constructive receipt of the cash, the exchange is dead.

Identification rules: 3-property, 200%, and 95%

Investors can identify multiple potential replacements within the 45-day window using one of three rules. Most use the 3-property rule, which allows up to three candidates regardless of value. The 200% rule allows more candidates as long as their combined fair market value does not exceed twice the relinquished property's sale price. The 95% rule is rarely used and requires acquiring at least 95% of the value of all identified properties.

Reverse and improvement exchanges

Two common 1031 variants give investors more flexibility under the same 45- and 180-day clocks. Both rely on an Exchange Accommodation Titleholder (EAT) under IRS Revenue Procedure 2000-37, which lets a third party temporarily hold title so the investor never owns both properties at once.

• Reverse 1031: acquire the replacement property first, then sell the relinquished property within 180 days.
• Improvement (build-to-suit) 1031: use exchange proceeds to construct improvements on replacement property while the EAT holds title.
• Both variants require the Qualified Exchange Accommodation Agreement (QEAA) to be in place within five business days of the EAT taking title.

What a 1031 actually costs

A standard delayed exchange usually costs roughly $600 to $2,500 in qualified intermediary fees. Reverse and improvement exchanges are more expensive because the EAT structure is more complex. These fees are typically much smaller than the federal tax that would otherwise be due, but they should still be modeled when deciding whether the exchange is worth the effort.

Where Lofty fits the 1031 picture

A 1031 exchange does not always require buying another whole property. Some investors use Delaware Statutory Trusts (DSTs) or Tenant-in-Common (TIC) interests to access fractional replacement property without managing the asset themselves. Lofty's product is different: it is a marketplace for buying fractional shares of individual U.S. rental properties, not a DST or TIC replacement property today. Investors searching for "1031 exchange into partial ownership" should work with a qualified intermediary, DST or TIC sponsor, and tax advisor before assuming any fractional structure qualifies.

Common reasons exchanges fail

Many failed 1031 exchanges trace back to avoidable process mistakes after the relinquished property has already closed.

• Missing the 45-day identification deadline because no acceptable replacement property surfaced in time.
• Identifying replacement properties that fall through and leave the investor without a backup option.
• Using an advisor who is disqualified because they recently acted as your attorney, CPA, broker, or agent instead of an independent qualified intermediary.
• Receiving cash, debt relief, or non-like-kind property at closing, creating taxable boot.

How to do a 1031 exchange

1. Engage a qualified intermediary before closing
   Hire an independent qualified intermediary (QI) to receive sale proceeds. Your own attorney, CPA, agent, or broker is generally treated as a disqualified person.

2. Sell the relinquished investment property
   Close the sale and have the QI receive proceeds directly. The 45-day and 180-day clocks both start on the closing date.

3. Identify replacement property within 45 days
   Deliver written identification of replacement candidates to the QI within 45 calendar days using the 3-property, 200%, or 95% rule.

4. Acquire replacement property within 180 days
   Close on the replacement property within 180 calendar days of the relinquished sale to complete the exchange.

5. Reinvest equal or greater value to fully defer
   Reinvest both equity and replacement debt of equal or greater value. Cash kept (cash boot) or debt not replaced (mortgage boot) is taxable in the year of exchange.

6. Report the exchange on Form 8824
   File IRS Form 8824 with that year's tax return to report the like-kind exchange and the carried-over basis to the replacement property.

Common 1031 exchange paths

• Traditional 1031 into a new rental
  Best for investors who want full control of the next property and have a target in mind.
  Tradeoff: Hardest to execute under the 45-day clock and reintroduces landlord work.

• Delaware Statutory Trust (DST) 1031
  Best for investors who want passive, institutionally-managed replacement property.
  Tradeoff: Sponsor fees, typically 5-10 year holds, and limited control over operations.

• Tenant-in-Common (TIC) 1031
  Best for co-investors splitting a single replacement property.
  Tradeoff: All TIC owners must agree on major decisions, which can stall sales or refinances.

• Pay the tax and reinvest freely
  Best for investors who want flexibility, lower minimums, or non-real-estate alternatives.
  Tradeoff: Capital gains, depreciation recapture, NIIT, and state tax can take 25% to 40% of the gain.

Risks of a 1031 exchange

• Boot is taxed immediately. Cash left in the exchange, debt that is not replaced, or non-like-kind property all create a partial tax bill, even on an otherwise valid exchange.
• Depreciation recapture is taxed at up to 25% federal and is often the largest single tax line on a long-held rental. A 1031 defers it, but does not erase it, it carries into the basis of the next property.
• Replacement property selection under a 45-day clock can pressure investors into deals they would not normally accept.
• State tax rules vary. Some states require ongoing tracking of deferred gains, which can create a later state tax bill.
• Estate planning strategies that rely on a step-up in basis at death assume the investor holds the exchanged property until death. Selling without another 1031 typically triggers the deferred federal tax.
• If a 1031 fails after the relinquished property has closed, the investor usually owes the entire tax bill, but no longer has the proceeds in hand, which can force a scramble for cash.

Frequently asked questions

What is a 1031 exchange in plain English?
A 1031 exchange lets you sell an investment property and roll the sale proceeds into another investment property without paying federal capital gains tax (or depreciation recapture) at the time of sale. The tax is deferred, not eliminated, and continues until you eventually sell without exchanging.

How long do I have to complete a 1031 exchange?
You have 45 calendar days from the sale of the relinquished property to identify replacement candidates in writing, and 180 calendar days total to close on the replacement property. Both deadlines run concurrently from the day the first property closes.

Do I need a qualified intermediary?
Yes. A qualified intermediary (QI) must hold the sale proceeds between transactions. If you take direct receipt of the cash, even briefly, the exchange is invalidated and the full tax bill comes due.

Can I do a 1031 exchange into partial ownership?
Sometimes, but only when the partial ownership structure itself qualifies. Delaware Statutory Trust (DST) and Tenant-in-Common (TIC) interests can qualify when properly structured. Most fractional real estate marketplaces, including Lofty, are not structured as DSTs or TICs today, so they do not qualify as 1031 replacement property. Always confirm with a qualified intermediary and tax advisor before closing.

What is depreciation recapture in a 1031?
Depreciation recapture is the portion of gain attributable to depreciation deductions previously claimed. On a regular sale it is taxed at up to 25% federal. A 1031 defers the recapture along with the rest of the gain, but the recapture amount carries into the basis of the new property.

What happens if my 1031 fails?
If the exchange fails, usually because of a missed deadline or a disallowed transaction, the IRS treats the original sale as fully taxable. You owe federal capital gains tax, depreciation recapture, NIIT (if applicable), and any state tax on the gain, often months after the proceeds left your hands.

Can you do a 1031 exchange on a primary residence?
Generally no. A 1031 exchange requires both the relinquished and replacement properties to be held for investment or business use. A primary residence does not qualify, though some mixed-use or converted properties may have both personal-residence and investment facts. Review the timing and documentation with a qualified intermediary and tax advisor before selling.

Sources

• Like-Kind Exchanges – Real Estate Tax Tips↗
  Internal Revenue Service

• Form 8824, Like-Kind Exchanges↗
  Internal Revenue Service

• Revenue Ruling 2004-86 (DST interests)↗
  Internal Revenue Service

• Section 1031 of the Internal Revenue Code↗
  Cornell Law School (Legal Information Institute)